UNIT –V (6Hrs)

National Income; Concepts and various methods of

its measurement,

Circular flows in 2 sector, 3 sector, 4 sector

economies,

Inflation, types and causes,

Business Cycle & its phases.

 National Income
• National income means the value (monetary value) of goods and services
produced by a country during a financial year.

• The National Income is the total amount of income accruing to a country from
economic activities in a years time.

• Thus, it is the net result of all economic activities of any country during a period of
one year and is valued in terms of money.

• National income is an uncertain term and is often used interchangeably with the
national dividend, national output, and national expenditure.
• Since these goods are measured in different physical units it is not possible to
add them together. Thus we cannot state national income is so many millions
of meters of cloth.

• Therefore, there is no way except to reduce them to a common measure. This

common measure is money. It includes payments made to all resources either
in the form of wages, interest, rent, and profits.

• The progress of a country can be determined by the growth of the national

income of the country.

• There are two concepts in National Income: GDP and GNP

 Gross Domestic Product

• The total value (monetary value) of goods produced and services rendered
within a country during a year is its Gross Domestic Product.

• Gross domestic product is the money value of all final goods and produced
in the services domestic territory of a country during an accounting year.

• Further, GDP is calculated at market price and is defined as GDP at market

prices.
Different constituents of GDP are:

1.Wages and salaries

2.Rent
3.Interest
4.Undistributed profits
5.Mixed-income
6.Direct taxes
7.Dividend
8.Depreciation
 Net Domestic Product (NDP)
• “NDP refers to the market value of all final goods and services
turned out in an economy during a given period of time after
making allowance for depreciation charges”

• NDP = GDP – Depreciation charges

 Gross National Product
• “GNP is defined as the total market value of all final goods and services
produced in a country in an year’s time.”

• GNP = GDP + X – M
• X=Income earned by nationals abroad
• & M=Income earned by foreigners in the given country.

• For calculation of GNP, we need to collect and assess the data from all
productive activities, such as agricultural produce, wood, minerals,
commodities, the contributions to production by transport, communications,
insurance companies, professions such (as lawyers, doctors, teachers, etc). at
market prices.
• It also includes net income arising in a country from abroad.

• Four main constituents of GNP are:

1.Consumer goods and services
2.Gross private domestic income
3.Goods produced or services rendered
4.Income arising from abroad.
 Net National Product (NNP)
• “NNP is the market value of the net output of final goods and services
produced by the country during the relevant income period”

• NNP = GNP – Depreciation charges

• NNP = NDP + X - M

• NNP gives idea net increase in total production of the country

 GDP and GNP on the basis of Market Price and
Factor Cost
• a) Market Price
• The Actual transacted price including indirect taxes such as GST, Customs
duty etc. Such taxes tend to raise the prices of goods and services in the
economy.

• b) Factor Cost
• It Includes the cost of factors of production e.g. interest on capital, wages to
labor, rent for land profit to the stakeholders. Thus services provided by
service providers and goods sold by the producer is equal to revenue price.
 Personal Income (PI)
• PI is the sum of all incomes all received by the individuals and
households in a during one year

• PI = NI – Corporate Income Taxes – Undistributed Profits – Social

Security contributions + Transfer Payments

• This concept help us to know the potential purchasing power of the

people and households and the welfare of consumers in society
 Disposable Personal Income (DPI)
• DPI is that part of personal income which is left after the payment of
personal direct taxes.

• DPI = PI – Personal Direct Taxes

• DPI = Consumption + Saving

• This concept indicates the purchasing power in the hands of the people and
their actual living standards
 Methods for measuring National Income:
• There are various methods for measuring National Income:
1. Gross Domestic Product (GDP)
2. Gross National Product (GNP)
3. Net National Product (NNP)
4. Net Domestic Product (NDP)
5. National Income at Factor Cost (NIFC)
6. Transfer Payments
7. Personal Income
8. Disposable Personal Income
 Methods of its Measurement,
• The national income of a country can be measured by three alternative methods:
(i) Product Method
(ii) Income Method, and
(iii) Expenditure Method

1. Product Method:
• In this method, national income is measured as a flow of goods and services. We
calculate money value of all final goods and services produced in an economy
during a year. Final goods here refer to those goods which are directly consumed
and not used in further production process.
• Goods which are further used in production process are called intermediate
goods.

• In the value of final goods, value of intermediate goods is already included

therefore we do not count value of intermediate goods in national income
otherwise there will be double counting of value of goods.

• To avoid the problem of double counting we can use the value-addition method
in which not the whole value of a commodity but value-addition (i.e. value of
final good value of intermediate good) at each stage of production is calculated
and these are summed up to arrive at GDP.

• For instance if the value of biscuit has been counted in national income then
value of intermediary goods like maida, sugar etc. is not count.
• Value added means the value added by each industry to the goods at each stage
of production.
• For Example; in the production of wheat, the farmer has added value to the
extent of Rs.0.50.
• The firm producing Maida has sold it at Rs. 1.00. It means that the firm
producing Maida has added value in it worth
• 1.00-0.50= 0.50 Rs.
• The baker sells the bread at Rs.2.00. It means he has added value worth
• 2.00-1.00= 1.00 Rs.
• In this way the total value added is –
• 0.50+ 0.50+1.00= 2.00 Rs., which is equal to the value of the final product
that is bread. Thus aggregate of value added is included in National
Income.
 (ii) Income Method
• Under this method, national income is measured as a flow of factor incomes. There
are generally four factors of production labour, capital, land and entrepreneurship.

• Labour gets wages and salaries, capital gets interest, land gets rent and
entrepreneurship gets profit as their remuneration.

• Besides, there are some self-employed persons who employ their own labour and
capital such as doctors, advocates, CAs, etc.

• Their income is called mixed income. The sum-total of all these factor incomes is
called NDP at factor costs.
(iii) Expenditure Method

• In this method, national income is measured as a flow of expenditure. GDP

is sum-total of private consumption expenditure.

• Government consumption expenditure, gross capital formation

(Government and private) and net exports (Export-Import).
 Circular flow of Income in Two Sector Economy

• The circular flow of income or circular flow is a model of the economy in

which the major exchanges are represented as flows
of money, goods and services, etc. between economic agents.

• According to circular flow of income in a two-sector economy, there are

only two sectors of the economy, i.e., household sector and
business sector.

• Government does not exist at all, therefore, there is no public

expenditure, no taxes, no subsidies, no social security contribution, etc.
• Household: It is a person or a group of people that share their income. The
members of households have two functions:
• They supply different factors of production.
• Members of household also work as consumers.

• Firms: An organization that produces goods and services for sale. Main
objective is to maximize profit in the production process.
The two main functions are as follows:
• Produce goods and services and supply them in the market.
• Firms purchase inputs or raw materials from households to use them in the
production process.
• Firstly, the household sector supply their factors of production or factor services (labor,
land, capital.) to the business sector through the factor market.
• Secondly the business sector pays the rewards to household sector for their contribution
to the production in kinds of rent for land, interest for capital, and wages for laborers.

• Thirdly business sector supply their outputs or goods and services in the goods or
product market.

• Fourthly household sector pays their income for consumption expenditure.

• Here we saw product market and factor market.

• Factor market refers to the market for selling and purchasing or hiring of factors
of production like labor, land.

• Product market means the market in which the goods and services are supplying
and demanding.
• When household save, their expenditure on goods & services will decline to that
extent and as a result money flow to the business firms will contract.

• With reduced money receipts, firm will hire fewer worker or reduce the factor
payments.

• This will lead to the fall in total incomes of the households. Thus, saving reduces
the flow of money expenditure to the business firms and causes a fall in
economy’s total income.

• Economists therefore call savings a leakage.

• Business firms borrow from the financial market for investment in capital goods
such as machines, factories, tools & instruments etc. Thus, saving again brought
into the expenditures stream and as a result total flow of spending does not
decrease. So, investment is called as injection to economy.
• We take many assumptions:

• In the first place, we assume that neither the households save from their incomes,
nor the firms save from their profits.

• We further assume that the government does not play any part in the national
economy.

• In other words, the government does not receive any money from the people by
way of taxes, nor does the government spend any money on the goods and
services produced by the firms or on the resources and services supplied by the
households.

• Thirdly, we assume that the economy neither imports goods and services, nor
exports anything.
• In other words, in our above analysis we have not taken into account the role of
foreign trade.

• In fact we have explained above the flow of money that occurs in the functioning of a
closed economy with no savings and no role of government.

• The income the government receives flows to firms and households in the form
of subsidies, transfers, and purchases of goods and services.

• Every payment has a corresponding receipt; that is, every flow of money has a
corresponding flow of goods in the opposite direction.

• As a result, the aggregate expenditure of the economy is identical to

its aggregate income, making a circular flow.
 Circular Flow in Sector 3 Economy

• The three-sector model adds the government sector to the two-sector

model. Thus, the three-sector model includes: (1) households, (2) firms,
and (3) government.

• It excludes the financial sector and the foreign sector. The government
sector consists of the economic activities of local, state and federal
governments.

• Flows from households and firms to government are in the form of taxes.
 Circular Flow in Sector 4 Economy
• The four-sector model adds the foreign sector to the three-sector
model. (The foreign sector is also known as the "external sector," the
"overseas sector," or the "rest of the world.")

• Thus, the four-sector model includes (1) households, (2) firms, (3)
government, and (4) the rest of the world.

• It excludes the financial sector. The foreign sector comprises

• (a) foreign trade (imports and exports of goods and services) and
• (b) inflow and outflow of capital (foreign exchange).
• Again, each flow of money has a corresponding flow of goods (or
services) in the opposite direction.

• Each of the four sectors receives some payments from the other in lieu
of goods and services which makes a regular flow of goods and
physical services.

• The addition of the foreign sector transforms the model from a closed
economy to an open economy!
 Inflation: Types and Causes
• Inflation is the decline of purchasing power of a given currency over
time.

• Most commonly used inflation indexes are the Consumer Price Index
(CPI) and the Wholesale Price Index (WPI).

• Inflation is an economic indicator that indicates the rate of rising

prices of goods and services in the economy.

• Ultimately it shows the decrease in the buying power of the rupee. It is

measured as a percentage.
 Types of Inflation
• The three types of Inflation are Demand-Pull, Cost-Push and Built-in inflation.
• Demand-pull Inflation: It occurs when the demand for goods or services is
higher when compared to the production capacity. The difference between
demand and supply (shortage) result in price appreciation.

• Cost-push Inflation: It occurs when the cost of production increases. Increase in

prices of the inputs (labour, raw materials, etc.) increases the price of the product.

• Built-in Inflation: Expectation of future inflations results in Built-in Inflation. A

rise in prices results in higher wages to afford the increased cost of living.
Therefore, high wages result in increased cost of production, which in turn has an
impact on product pricing. The circle hence continues.
 Causes of Inflation
• Monetary Policy: It determines the supply of currency in the market. Excess
supply of money leads to inflation. Hence decreasing the value of the currency.
• Fiscal Policy: It monitors the borrowing and spending of the economy. Higher
borrowings (debt), result in increased taxes and additional currency printing to
repay the debt.
• Demand-pull Inflation: Increases in prices due to the gap between the demand
(higher) and supply (lower).
• Cost-push Inflation: Higher prices of goods and services due to increased cost
of production.
• Exchange Rates: Exposure to foreign markets are based on the dollar value.
Fluctuations in the exchange rate have an impact on the rate of inflation.
 Business Cycle
• The term “business cycle” or “trade cycle” in economics refer to have the wave-
like fluctuations in the aggregate economic activity, particularly in employment,
output and income. In other words, trade cycles are ups and downs in economic
activity.

• The business cycle refers to the cyclical variation in economic activity.

• The term “business cycle” (or economic cycle or boom-bust cycle) refers to
economy-wide fluctuations in production, trade, and general economic activity.

• The business cycle, also known as the economic cycle or trade cycle, are the
fluctuations of gross domestic product (GDP) around its long-term growth trend.
• The length of a business cycle is the period of time containing a single
boom and contraction in sequence.
• "Business cycles are a type of fluctuation found in the aggregate economic
activity of nations”.
• From a conceptual perspective, the business cycle is the upward and
downward movements of levels of GDP (gross domestic product) and refers
to the period of expansions and contractions in the level of economic
activities (business fluctuations) around a long-term growth trend.

• Features:
• A trade cycle is a wave-like movement.
• Cyclical fluctuations are recurrent in nature.
• Expansion and contraction in a trade cycle are cumulative in effect.
• Trade cycle is characterized by the presence of a crisis.
• Expansion: when all macro economic variables like output, employment,
income and consumption increase. Prices move up, money supply increases, self
reinforcing feature of business cycle pushes the economy upward.

• Peak: the highest point of growth; referred to as boom. Stage beyond which no
further expansion is possible,
• Sees the downward turning point.

• Contraction/Recession: means the slowing down process of all economic

activities.

• Trough or Slump: the lowest ebb of economic cycle.

• Followed by the next turning point in the cycle, when new growth process starts
afresh.
Phases of a Trade Cycle
• A trade cycle is commonly divided into four categories or phases:

1.Prosperity Phase: Expansion or the upswing

2. Recessionary Phase: A turn from prosperity to depression.

3. Depressionary phase: Contraction or downswing

4. Revival or Recovery Phase: The turn from depression to prosperity

 Prosperity:
• “A prolonged period of growing business and economic activity.”
• The features of prosperity are:
• High level of employment and income
• High level of output and trade
• High level of effective demand
• Large expansion of bank credit
• Overall business optimism
• Industrial growth rate accelerates
• Investment increase
• Money supply increase
 Recession Phase
• When prosperity ends, the recession begins. Recession relates to a turning point rather
than a phase.

• Liquidation in the stock market, repayment of bank loans and the decline of prices are
its outward symptoms.

• During a recession, businessmen lose the confidence. Everyone feels pessimistic about
future profitability of investment. Hence, investment will be drastically curtailed and
production of capital goods industries will fall.

• Businesses expansion stops, orders are cancelled and workers are laid off.
• Reduced income causes a decrease in aggregate expenditure and thus the
general demand falls, in turn, prices, profits and business decline.

• There is a general drive to contract the scale of operations, leading to

increase in unemployment; thus income throughout the economy falls.
 Depressionary Phase
• During the depression, the most deplorable conditions prevail in the economy.
• The features of depression are:
• Shrinkage in the volume of output, trade and transactions
• Rise in the level of unemployment
• Price deflation
• Fall in the aggregate income of community
• Fall in the structure of interest rates
• Curtailment in consumption expenditure and reduction level of effective
demand.
 Recovery Phases
• The revival or recovery phase refers to the lower turning point at
which an economy undergoes changes from depression to prosperity.
• Within