Unit 2

National Income Accounting LH 7

Circular flow of income and expenditure (two, three and four sector
economy),
Meaning of national income: Various concepts of NI: GDP, NDP,
GNP and NNP (both in – market price and factor cost terms),
Nominal GDP, Real GDP and GDP deflator,
Potential and actual GDP,
Personal income, Disposable income and Saving, Per capita income.
Three approaches of measurement of NI (Product, Income and
Expenditure), Measurement Difficulties of NI.
Numerical assignments and Case studies
Circular flow of income and expenditure
An economy is an integrated activity for production, distribution,
and consumption. These economic transactions generate two kinds of
flows: flow of goods/ services and flow of money. Product and money
flow in opposite direction.
The economy is divided into four sectors; household sector,
business sector, government sector and foreign sector. The circular flow
of income and expenditure can be studied under three models.
Circular flow of income and expenditure in two sector economy
Circular flow of income and expenditure in three sector economy
Circular flow of income and expenditure in four sector economy
1. Circular flow of income and expenditure in two sector economy
The two sector economy consists of only household and business sector.
The government and foreign sector are ignored in this economy so it is
also called two sector closed economy and not found in real world.
Assumptions
Only two sectors i.e. household and business sectors.
All income is spent in consumption i.e. no saving.
No government and foreign trade.
Household provide factors of production to business sectors and
consume products produced by business sectors.
2. Circular flow of income and expenditure in three sector economy
It consists of three sectors i.e. household sector, business sector, and
government sector. Since there is absence of foreign sector, it is also
called three sector closed economy. Though it is more realistic than two
sector, it rarely exist in present world.
Assumptions
Three sectors i.e. household, business and government.
There is government intervention and the government imposes taxes
and grants subsidies.
No export and import.
Household pays only direct tax and business sector pays both direct
and indirect tax to the government.
There is presence of financial market to regulate saving and
investment.
3. Circular flow of income and expenditure in four sector economy
This economy consists of all four sectors. It is also called open
economy. It is the most realistic and practical form of economy among
all.
Assumptions
There are four sectors in the economy i.e. household, business,
government and foreign sectors.
There is minimum government intervention
There is no restriction in international trade.
Perfect competition in bot internal and external market.
Household export labor and capital.
Business firms export and import goods and services.
Meaning of National Income
In general, national income is the sum of income earned by all
individuals of a nation in a particular period of time. In other words, the
sum of market value of all goods and services produced by the economy
of a nation in a year is called national income. So, we can write,
NI = Y1 + Y2 + Y3 + ... + Yn
According to Marshall,” The labor and capital of a country acting
upon its natural resources produce annually a certain net aggregate of
commodities, material and immaterial including services of all kind.
This is the net annual income or revenue of a country or the national
dividend.”
Various concepts of national income
Gross Domestic Product (GDP)
Gross National Product (GNP)
Net Domestic Product (NDP)
Net National Product (NNP)
National Income (NI)
Personal Income (PI)
Disposable Income (DI)
Per Capita Income (PCI)
1. Gross Domestic Product (GDP)
The market value of all final goods and services produced within the
domestic territory of a country during a year is called gross domestic
product. It includes only final goods and services, that means
intermediate products are excluded from measurement of GDP. For
calculating GDP, the quantity of all final goods and services produced
are multiplied with their respective prices and then summed up.
Symbolically,
GDP = P1Q1 + P2Q2 + ... + PnQn
where, P = Market price of final goods and services
Q = Quantity of goods and services
n = Total number of final goods and services
GDP at Market Price (MP) and Factor Cost (FC)
GDP measured at the actual market price which is paid by the
consumers or producers for purchasing goods and services is called
GDP at market price. If GDP is measured as the sum of price paid to all
the factors of production in the form of wages, rent, interest and profit,
it is called GDP at factor cost. We can calculate GDP at FC by deducting
net indirect tax from GDP at MP.
GDP at MP (GDPMP) = P1Q1 + P2Q2 + ... + PnQn
GDP at FC (GDPFC) = GDPMP – Net indirect taxes
Net Indirect taxes = Indirect tax - Subsidies
2. Net Domestic Product (NDP)
When we deduct depreciation from GDP, we get NDP. Depreciation is
the decrease in value of fixed capital assets. It is also called capital
consumption allowance.
NDP = GDP – Depreciation
NDP at MP and FC
NDPMP = GDPMP – Depreciation
NDPFC = NDPMP – Net indirect taxes
Net indirect taxes = Indirect taxes - subsidies
3.Gross National Product (GNP)
GNP is the market value of all final goods and services produced during
a year by using domestically owned resources. When we add Net Factor
Income from Abroad(NFIA) to GDP, then we get GNP. NFIA is the
difference between factor income earned by our residents from foreign
countries and the factor income earned by foreigners from our country.
GNPMP = GDPMP +NFIA
GNPFC = GNPMP – Net indirect taxes
4. Net National Product (NNP)
During production of goods and services, machineries and other fixed
assets wear and tear which is called depreciation. NNP is the market
value of all final goods and services after allowing for depreciation. We
get NNP by subtracting depreciation from GNP.
NNPMP = GNPMP – Depreciation
NNPFC = NNPMP – Net indirect tax
5.National Income (NI)
NI is the total sum of earnings of all factors of production in the form of
wages, profit, rent and interest plus Net factor income from abroad. The
sum of these earnings of factors of production is NDPFC. When we add
NFIA to NDPFC, we get NI. In other words, NNPFC is equal to NI.
NDPFC = W + R + I + P
Where, W = Wages and salaries
R = Rent
I = Interest
P = Profit
NNPFC = NDPFC + NFIA
NI = NNPFC
Other things remaining same

Gross to Net Less depreciation

Domestic to National Add NFIA

Market Price to Factor Cost Less Net Indirect Tax

(MP to FC)
6. Personal Income (PI)
The total income received by all individuals and households of a
country from all possible sources before payment of direct taxes during
a year is called personal income. It is never equal to the national income
because the factors of production do not get all parts of income they
earn. We can calculate PI by using following formula.
PI = NI – Undistributed corporate profit - Corporate income tax –
Social security contribution + Transfer payments
7. Disposable Income (DI)
The total income received by all individuals and households of a
country from all possible sources after payment of direct taxes is called
disposable income.
So, we can write
DI = PI – Direct taxes
Some part of disposable income is spent on consumption and some part
of it is saved. So,
DI = Consumption (C) + Saving (S)
8. Per Capita Income (PCI)
The average income of the people of a country in a particular year is
called per capita income. It is expressed at the current prices. For
calculating PCI, national income of a country in a particular year is
divided by population of the country in that year.
Per Capita Income for 2020
= National Income for 2020 / Population for 2020
Nominal GDP, Real GDP and GDP Deflator
Nominal GDP is the GDP evaluated at current market prices. So, it
includes all the changes in market price that have occurred during the
current year due to inflation or deflation.
Real GDP is defined as the GDP evaluated at the market price of any
base year. Real GDP is used to remove the effect of changes in overall
price level due to inflation or deflation.
GDP Deflator
GDP deflator measures the relative changes in current price level in
comparison to the price level of base year. In other words, it is the ratio
of nominal GDP to real GDP of a certain year.
Day 4

Measurement of national income

In an economy, there is circular flow of production, income and
expenditure. Based on these inter-related flows, national income can
be measured by using three methods.
Income method
Product method
Expenditure method
1. Product method
This method measures national income at the phase of production. In
this method, economy is divided into three sectors:
Primary sector(agriculture, forestry, fishing, mining, etc.)
Secondary sector (manufacturing, construction, electricity, etc.)
Tertiary or service sector (banking, transport, communication,
insurance, etc.)
The money value of total product of each sector is summed up to
calculate GDP at MP. The following two methods are used to calculate
NI under product approach.
a. Final product method
b. Value added method
a. Final product method
In this method, national income is calculated by finding the market value
of all final goods and services produced in an economy during a year. The
steps of calculating national income by using this method are given
below:
GDPMP= Market value of all final goods and services produced in all
three sectors(primary, secondary and tertiary)
=P1Q1 +P2Q2+ ... +PnQn
GNPMP = GDPMP +NFIA
NNPMP = GNPMP – Depreciation
NNPFC or NI =NNPMP – Net Indirect tax
The process of counting the same good or service for more than once
during the calculation of national income is called double counting.

While calculating NI through final product method, problem of double

counting occurs. It leads to over estimation of national income. Some
products are used as final as well as intermediate products e.g. flour is
used as final product by households whereas it is used as intermediate
product by biscuit and noodle industries. So, it is difficult to calculate
the value of only final goods by excluding the value of intermediate
goods. To avoid this problem of double counting, value added method
is used.
b. Value added method
In this method, the value added or created at different stages of
production is counted to estimate the national income. According to
this method, national income is the sum of value added by different
producing units of a country in their production process. For
calculating the value added at a particular stage of production, the cost
of intermediate product is deducted from the total value of output.
Gross value added = Value of output – cost of intermediate goods
GDPMP = Gross value added by all sectors of an economy
=(P1Q1 + P2Q2 + ... +PnQn) – Value of raw materials used
GNPMP = GDPMP + NFIA
NNPMP = GDPMP – Depreciation
NNPFC = NNPMP – Net Indirect tax
Day 5
2. Income Method(Factor payment method)
In this method, the income received by the residents of a country for their
aid in production during a year is used to calculate national income. The
income earned by all individuals and households for using factors of
production(land, labour, capital, etc.) in the form of wages, salaries, interest,
rent and profit are summed up to calculate NDPFC.
Components used in income method
Compensation of employees= wages and salaries + Employers contribution
to social security(provident fund) + bonus + Money value of other facilities
+ commissions + Fringe benefits
Rent
Interest
Profit= Undistributed profit + Dividend + Corporate income tax
Mixed income and income from self employment or Proprietor’s income
Steps for calculating NI using income method
NDPFC = compensation of employees/wages & salaries + Rent +
profit + interest + Income from self employment or Proprietor’s
income
NNPFC =NI = NDPFC + NFIA
OR
GDPMP = Compensation of employees +Rent + Profit +Interest +
Income from self employment + Net Indirect tax + Depreciation
NI = NNPFC = GDPMP – Depreciation – Net Indirect tax + NFIA
Note: Rent + Interest + Profit = Operating Surplus
Depreciation is also called ‘Capital consumption allowance’ or
‘Consumption of fixed capital’
Day 6
3. Expenditure method
In this method, the expenditures made by all four sectors of the
economy(household, business, government and foreign) are summed
up to calculate GDPMP.
Components used for expenditure method
Personal consumption expenditure(C)
Gross private domestic investment (I) = Net fixed capital formation +
Depreciation + Change in stock
Change in stock = Closing stock – Opening stock
Government expenditure (G)
Net export (X - M) = Export (X) – Import(M)
Steps for calculating national income
GDPMP = C + I + G + (X - M)
GNPMP = GDPMP + NFIA
NNPMP = GNPMP – Depreciation
NNPFC = NNPMP – Net Indirect tax
Day 7
Need or Importance of National Income Accounting
Indicator of economic structure of a nation
Indicator of international comparison
 Helpful to formulate economic policies and planning
Inflationary and deflationary gaps
Basis of budgetary policies
Importance of defense and development
Importance in developing countries
Important in economic analysis
Difficulties in the measurement of National Income
Double counting
Calculation of depreciation
Change in value of money(price level)
Illegal income
Non-availability of reliable data
Choice of method
Non-market activities
Inclusion of services
Unreported income
Intermediate goods