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National Income
LECTURE PLAN
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Objectives
Circular Flow of Economic Activities and Income
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Two Sector Model
Four Sector Model
Macroeconomic variables
Concepts of National Income
Measuring National Income
Uses of National Income Data
Difficulties in Measurement of National Income
OBJECTIVES
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To explain the circular flow of economic activity and
income.
To introduce the concepts of aggregates, stock and
flow and final goods.
To explain various concepts of national income, like
GDP, GNP and NNP.
To discuss and analyze the different methods to
measure national income.
To understand the advantages of national income
calculation in global perspective.
CIRCULAR FLOW OF ECONOMIC ACTIVITIES
Economic interdependence of Consumers and
Sellers.
 Between Consumers and Sellers the circular
Flow of Goods, Services, Income and
Expenditure takes place.
 Other Entities may be Foreign Nations,
Government.
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CIRCULAR FLOW OF ECONOMIC
ACTIVITIES AND INCOME (TWO SECTOR
ECONOMY)
The simple model of the circular flow assumes two players
Firms
 Produce and supply the goods and services.
 Require various factors of production to produce these goods and
services.
Households
 Include a set of individuals living in the same house
 Take joint decision about the consumption of goods and services.
 Provide services in terms of factor inputs to the firms
 Get paid for these services by firms which households spend on
consumption.
 Money flows from firms to households as factor payments and from
households to firms as expenditure on goods and services.
 It is a circular flow of money or income
Savings are taken out of Circular flow, so these
are called “Withdrawals”
 Savings deposited in Capital Markets goes to
the firms as Investment Expenditure, which is
known as known as “Injections”.
 If Savings are kept with households, it is known
as “Leakages”.
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CIRCULAR FLOW OF INCOME
(TWO SECTOR ECONOMY)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)
Factor Inputs
Households
Savings
(S)
Financial
Market
Investment
(I)
Goods and
Services (O)
Consumption
expenditure
(C)
In the equilibrium Y=C+S=C+I
Firms
EQUILIBRIUM
Aggregate Income = Aggregate Expenditure
Y=E
 Aggregate Income = C+S
 Aggregate Expenditure = C+I
S=I
 Hence Y = E or
 Aggregate Demand = Aggregate Expenditure
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THREE SECTOR MODEL
Total Expenditure (E)= C+I+G
 Total Income (Y) = C+S+T
 In Equilibrium E = Y
 So C+I+G = C+S+T
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CIRCULAR FLOW OF INCOME
(FOUR SECTOR ECONOMY)
The third sector is Government (G)
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Government Spending
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Subsidies, defence, health care, education, infrastructure
Provides salaries to the households
Pays to firms for purchases of goods and services
Government Revenue
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Households and firms pay various taxes and other payments and
provide factor inputs to the government.
Government borrows from the financial market to fill revenue gap.
The fourth sector is the external sector
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Imports (M): Outflow of income occurs when the domestic firms buy
goods and services from foreign ones.
Exports (X): Inflow of income takes place when foreign firms buy
goods and services from domestic ones
C+I+G=C+S+T
CIRCULAR FLOW OF INCOME
(FOUR SECTOR ECONOMY)
Government
(G)
Taxes
Taxes
Factor
Payments
Remittances
for purchases
Factor Inputs
Salaries
Households
Savings
(S)
Imports
(M)
Financial Market
Investment
(I)
Imports
(M)
Goods
(O)
Consumption
Expenditure
Exports
(X)
Foreign Nations
(X-M)
Firms
Exports
(X)
National Income=C+I+G+(X-M)
MACRO-ECONOMIC VARIABLES
 Aggregate
 Aggregate
Demand and Aggregate Supply
Demand is the sum of demand for all goods and
services by all the consumers for a given period of time.
 aggregate demand (AD) for consumer goods i.e.
consumption demand (C)
 aggregate demand for capital goods i.e. (I).
Thus AD = C+I
 Aggregate supply is the total national output produced and supplied
by all the factors of production in an economy.
 It refers to the supply of all goods and services in the economy for a
given period of time.
 Aggregate supply (AS) consists of
 supply of consumer goods (C) and
 Supply capital goods (where capital comes from savings (S),
Hence AS=C+S
NATIONAL INCOME
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National income is defined as the money value of all the
final goods and services produced in an economy during an
accounting period of time, generally one year.
Concepts of National Income
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Gross Domestic Product (GDP)
Gross National Product (GNP)
Net Domestic Product (NDP)
Net National Product (NNP)
Per Capita Income
GROSS DOMESTIC PRODUCT
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Gross Domestic Product (GDP): GDP is the sum of
money values of all final goods and services produced
within the domestic territories of a country during an
accounting year.
GDP= C+I+G+(X-M)
GDP at market price: includes the final value of goods
and services also includes indirect taxes and excludes
the subsidies given by the government.
GDP at factor cost is the money value of final goods
and services based on the cost involved in the process
of production.
Gross Domestic Product at factor cost
= GDP at Market Prices –Indirect Taxes+ Subsidies
GROSS NATIONAL PRODUCT
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Gross National Product (GNP): GNP is the aggregate
final output of citizens and businesses of an economy in
a year.
GNP may be defined as the sum of Gross Domestic
Product and Net Factor Income from Abroad (NFIA).
GNP = GDP + NFIA
GNP = C+I+G+(X-M)+NFIA
Net Factor Income from Abroad: difference between
income received from abroad for rendering factor
services and income paid towards services rendered by
foreign nationals in the domestic territory of a country.
NET DOMESTIC PRODUCT AND
NET NATIONAL PRODUCT
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Net Domestic Product
= GDP-Depreciation
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Net National Product (NNP)
= GDP–Depreciation +NFIA
Or =GNP–Depreciation
Thus NNP is the actual addition to a year’s wealth and is the sum of
consumption expenditure, government expenditure, net foreign
expenditure, and investment, less depreciation, plus net income earned
from abroad.
= C+I+G+(X–M)–Depreciation + NFIA
NNP at Factor Cost is the sum total of income earned by all the people
of the nation, within the national boundaries or abroad
It is also called National Income.
NNP at Factor Cost = NNP at Market Prices –Indirect Taxes+ Subsidies
REAL AND NOMINAL NATIONAL
INCOME
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National income estimated at the prevailing prices, is called national
income at current prices or Nominal National Income, or Money
National Income or national income at current prices.
National income measured on the basis of some fixed price, say
price prevailing at a particular point of time, or by taking a base year,
is known as national income at constant prices, or Real National
Income or national income at constant prices.
Nominal GDP
Real GDP =
GDP deflator
•GDP deflator is the ratio of nominal GDP in a year to real GDP of that year
•GDP deflator measures the change in prices between the base year and
the current year.
PER CAPITAL INCOME AND
PERSONAL INCOME
• Per capita income is the average income of the people of
a country in a particular year.
Per Capita Income =
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National Income
Total Population
Personal income is the total income received by the
individuals of a country from all sources before direct taxes
in one year.
Personal Income = National Income –Undistributed Corporate Profits –
Corporate Taxes – Social Security Contributions + Transfer Payments
+ Interest on Public Debt
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Personal Disposable Income is the income which can be
spent on consumption by individuals and families.
Personal Disposable Income = Personal Income – Personal Taxes
METHODS OF MEASURING
NATIONAL INCOME
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Hence there are three approaches to the
measurement of GDP:
Product (or Output) Method: National Income by
Industry of Origin
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Final Product Method
Value Added Method
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Income Method or National Income by Distributive
Shares
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Expenditure Method
PRODUCT (OR OUTPUT) METHOD
The market value of all the goods and services produced
in the country by all the firms across all industries are
added up together.
Process
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The economy is divided on basis of industries, such as
agriculture, fishing, mining and quarrying, large scale
manufacturing, small scale manufacturing, electricity, gas, etc.
The physical units of output are interpreted in money terms
The total values added up. (GDP or GNP at market price)
The indirect taxes are subtracted and the subsidies are added.
(GDP at factor cost)
Net value is calculated by subtracting depreciation from the total
value (NDP at factor cost).
LIMITATIONS OF PRODUCT
METHOD
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Problem of Double Counting:
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Not Applicable to Tertiary Sector:
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This method is useful only when output can be
measured in physical terms
Exclusion of Non Marketed Products
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unclear distinction between a final and an
intermediate product.
E.g. outcome of hobby
Self Consumption of Output
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Producer may consume a part of his production.
INCOME METHOD
The net income received by all citizens of a country in a particular
year, i.e. total of net rents, net wages, net interest and net profits.
(GDP at factor cost).
 It is the income earned by the factors of production of a country.
 Add the money sent by the citizens of the nation from abroad and
deduct the payments made to foreign nationals (individuals and firms)
(GNP at factor cost) or Gross National Income (GNI).
Process:
• Economy is divided on basis of income groups, such as
wage/salary earners, rent earners, profit earners etc.
• Income of all the gruops is added, including income from abroad
and undistributed profits.
• The income earned by foreigners and transfer payments made in
the year are subtracted.
GNP at factor cost = Rent + Wage + Interest +Profit + Net Income from
Abroad- Transfer payments
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LIMITATIONS OF INCOME METHOD
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Exclusion of non monetary income: Ignores the nonmonetized section of economic activities.
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Economic activities that contribute to national income, but due to
their non monetary nature, they go unrecorded. For e.g. a farmer
and family working in their own field.
Exclusion of Non Marketed Services: People
undertake a particular activity that are difficult to ascertain
in money value. E.g. mother’s services to the family.
EXPENDITURE METHOD OF MEASURING
NATIONAL INCOME
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The total expenditure incurred by the society in a
particular year is added together to get that year’s
national income.
Components of Expenditure:
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personal consumption expenditure
net domestic investment :capital, residential and inventory
investment
government expenditure on goods and services, and
net foreign investment
Limitations
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Ignores Barter System
Ignores Own Consumption
Affected by Inflation
USES OF NATIONAL INCOME
DATA
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National income is the most dependable indicator of a
country’s economic health.
Difference between GDP and GNP indicates the
contribution of net income earned abroad
Necessary for Economic planning: useful aid in judging
which sectors should be given more emphasis
A measure of economic welfare.
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higher aggregate production implies more and more goods and
services being available to people
Helps in determining the regional disparities, income
inequality and level of poverty in a country.
Helps in comparing the situations of economic growth in
two different countries.
DIFFICULTIES IN MEASUREMENT OF
NATIONAL INCOME
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Non monetized transactions: Exchange of goods and services
which have no monetary payments, like services rendered out of
love, courtesy or kindness are difficult to include in the computation
of national income.
Unorganized sector: Contribution of unorganized sector are
unrecorded. It is very difficult to identify income of those who do not
pay income tax.
Multiple sources of earnings: Part time activity goes
unrecognized and such income is not included in national income.
Categorization of goods and services: In many cases
categorization of goods and services as intermediate and final
product is not very clear.
Inadequate data: Lack of adequate and reliable data is a major
hurdle to the measurement of national income of underdeveloped
countries.
INFLATION
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Coulborn: it is a state of “too much money chasing too few goods”.
Two broad categories:
 price inflation (generally called as inflation)
 money inflation.
Both have cause and effect relationship, i.e. money inflation leads to price
inflation.
 Money inflation is increase in the amount of currency in circulation.
Which may be due to:
 Deficit financing : direct cause is printing of additional currency on
demand of the government to meet its needs.
 Additional money supply through foreign exchange inflows in the
form of capital, such as foreign direct investment and foreign
institutional investment, tourism and other incomes from abroad.
Price inflation is a persistent increase in the general price
level or a persistent decline in the real income of people, i.e.
decline in value of money.
CONCEPTS OF INFLATION
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Headline Inflation: Headline inflation is a measure of the
total inflation within an economy, including commodities such as food and
energy prices (e.g., oil and gas), which tend to be much more volatile and
prone to inflationary spikes.
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Hyperinflation: prices increase at such a speed that the value of money
erodes drastically
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This is also known as galloping inflation or runaway inflation.
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Stagflation: a typical situation when stagnation and inflation coexist. (Slow
economic growth + Inflation).
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Suppressed Inflation: Petrol and diesel prices
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Disinflation: a well planned process to bring down the prices moderately.
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Deflation: a state when prices fall persistently; just opposite to inflation
INFLATION AND DECISION MAKING
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Impact on Consumers
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increase in any price upsets the home budget.
Impact on Producers (or Suppliers)
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Producers as sellers are benefited by inflation;
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higher the prices, higher are their profits.
when as buyers of raw material, they are adversely affected by inflation.
Impact on Government:
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Government has to take the economy to higher levels of growth by
encouraging production and investment,
At the other end, has to see that taxpayers’ money is not eroded by
hyperinflation.
Thus government has to act as the balancing force between consumers
and sellers.
MEASUREMENT OF INFLATION
Price Index =
 (Current Year’s Price/Base Year’s Price)*100
 Consumer Price Index
 Wholesale Price Index
 GDP Deflator
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CONTROL OF INFLATION
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Inflation erodes the value of money and discourages
savings
But zero inflation is undesirable
Need to control inflation
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monetary policy measures (proposed by those who believed
money supply is the major culprit)
fiscal policy measures (proposed by Keynes and his
followers).
Other measures
The government has to adopt an appropriate
combination of these measures after thorough
examination of the causes of inflation
MONETARY POLICY MEASURES
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Increasing the bank rate (increasing repo rate)
Higher reserve ratios:
 Cash
Reserve Ratio (CRR)
 Statutory Liquid Ratio (SLR)
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Open market operations: directly sell government
securities to public and restrain their disposable
income
Selective credit control: selective credit control (SCC)
on advances by banks against the mortgage of
sensitive commodities such as rice, wheat, oilseeds,
etc. It is out of fashion now.
FISCAL POLICY MEASURES
The government may reduce public expenditure or increase
public revenue to keep a check on inflation
 Reducing public expenditure
 When government spends on activities like health,
transport, communication, etc., income of individuals
increases; this in turn increases the aggregate demand.
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Therefore the reverse will also be true.
Increasing public revenue
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Major source of government revenue is various types of taxes
Increase in income tax leaves less of disposable income in the
hands of consumers
INDEXATION
Indexation is a technique to adjust income
payments by means of a price index, in order to
maintain the purchasing power of the public
after inflation
 Indexation is the Automatic Linkage between
Monetary Obligations and Price Levels.
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