Circular Flow Of Income And Methods Of Calculating National Income


Let us consider a simplified version of economy where there is –

  • no government;
  • no external trade;
  • households do not save;
  • households do not pay taxes to the government as there is no government.

There may fundamentally be four kinds of contributions that can be made during the production of goods and services –

  • (a) contribution made by human labour, remuneration for which is called wage
  • (b) contribution made by capital, remuneration for which is called interest
  • (c) contribution made by entrepreneurship, remuneration of which is profit
  • (d) contribution made by fixed natural resources (called ‘land’), remuneration for which is called rent.

In this simplified economy, there is only one way in which the households may dispose off their earnings – by spending their entire income on the goods and services produced by the domestic firms. The other channels of disposing their income are closed as we have assumed it’s a simple economy. In other words, factors of production use their remuneration to buy the goods and services which they assisted in producing.

The aggregate consumption by the households of the economy is equal to the aggregate expenditure on goods and services produced by the firms in the economy. The entire income of the economy, therefore, comes back to the producers in the form of sales revenue. There is no leakage from the system – there is no difference between the amount that the firms had distributed in the form of factor payments (which is the sum total of remuneration earned by the four factors of production) and the aggregate consumption expenditure that they receive as sales revenue.

In the next period the firms will once again produce goods and services and pay remuneration to the factors of production. These remunerations will once again be used to buy the goods and services. Hence year after year we can imagine the aggregate income of the economy going through the two sectors, firms and households, in a circular way.

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When the income is being spent on the goods and services produced by the firms, it takes the form of aggregate expenditure received by the firms. Since the value of expenditure must be equal to the value of goods and services, we can equivalently measure the aggregate income by calculating the aggregate value of goods and services produced by the firms. When the aggregate revenue received by the firms is paid out to the factors of production it takes the form of aggregate income.

In the above figure –

  • The uppermost arrow, going from the households to the firms, represents the spending the households undertake to buy goods and services produced by the firms. The second arrow going from the firms to the households is the counterpart of the arrow above. It stands for the goods and services which are flowing from the firms to the households. In other words, this flow is what the households are getting from the firms, for which they are making the expenditures. In short, the two arrows on the top represent the goods and services market – the arrow above represents the flow of payments for the goods and services, the arrow below represents the flow of goods and services.
  • The two arrows at the bottom of the diagram similarly represent the factors of production market. The lower most arrow going from the households to the firms symbolises the services that the households are rendering to the firms. Using these services the firms are manufacturing the output. The arrow above this, going from the firms to the households, represents the payments made by the firms to the households for the services provided by the latter.

Since the same amount of money, representing the aggregate value of goods and services, is moving in a circular way, if we want to estimate the aggregate value of goods and services produced during a year we can measure the annual value of the flows at any of the dotted lines indicated in the diagram. We can measure the uppermost flow (at point A) by measuring the aggregate value of spending that the firms receive for the final goods and services which they produce.

This method will be called the expenditure method. If we measure the flow at B by measuring the aggregate value of final goods and services produced by all the firms, it will be called product method. At C, measuring the sum total of all factor payments will be called income method.

Observe that the aggregate spending of the economy must be equal to the aggregate income earned by the factors of production (the flows are equal at A and C).

Now let us suppose that at a particular period of time the households decide to spend more on the goods and services produced by the firms. For the time being let us ignore the question where they would find the money to finance that extra spending since they are already spending all of their income (they may have borrowed the money to finance the additional spending). Now if they spend more on the goods and services, the firms will produce more goods and services to meet this extra demand. Since they will produce more, the firms must also pay the factors of production extra remuneration. How much extra amount of money will the firms pay? The additional factor payments must be equal to the value of the additional goods and services that are being produced. Thus the households will eventually get the extra earnings required to support the initial additional spending that they had undertaken.

In other words, the households can decide to spend more – spend beyond their means. And in the end their income will rise exactly by the amount which is necessary to carry out the extra spending.

Putting it differently, an economy may decide to spend more than the present level of income. But by doing so, its income will eventually rise to a level consistent with the higher spending level.

This may seem a little paradoxical at first. But since income is moving in a circular fashion, it is not difficult to figure out that a rise in the flow at one point must eventually lead to a rise in the flow at all levels. This is one more example of how the functioning of a single economic agent (say, a household) may differ from the functioning of the economy as a whole. In the former the spending gets restricted by the individual income of a household. It can never happen that a single worker decides to spend more and this leads to an equivalent rise in her income.

The above mentioned sketchy illustration of an economy is admittedly a simplified one. Such a story which describes the functioning of an imaginary economy is called a macroeconomic model. It is clear that a model does not describe an actual economy in detail. For example, our model assumes that households do not save, there is no government, no trade with other countries. However models do not want to capture an economy in it’s every minute detail – their purpose is to highlight some essential features of the functioning of an economic system. But one has to be cautious not to simplify the matters in such a way that misrepresents the essential nature of the economy. The subject of economics is full of models. One task of an economist is to figure out which model is applicable to which real life situation.

If we change our simple model described above and introduce savings, will it change the principal conclusion that the aggregate estimate of the income of the economy will remain the same whether we decide to calculate it at A, B or C? It turns out that this conclusion does not change in a fundamental way. No matter how complicated an economic system may be, the annual production of goods and services estimated through each of the three methods is the same.

We have seen that the aggregate value of goods and services produced in an economy can be calculated by three methods. Lets now understand the detailed steps of these calculations at –

  • The Product Or Value Added Method
  • Expenditure Method
  • Income Method

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Bibliography : NCERT – Introductory Macroeconomics

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