Circular Flow of Income and Methods of Calculating National Income

What is Circular Flow of Income?

The circular flow means the unending flows of production of goods and services, income and expenditure in an economy. It shows the redistribution of income in a circular manner between the production unit and households.

These are Land, Labour, Capital and Entrepreneurship

  • The contribution made by fixed natural resources (called ‘land’), payment for which is called ‘rent’
  • The contribution made by a human worker (labour), payment for which is called ‘wage’.
  • The contribution made by capital, payment for which is called ‘interest’.
  • The contribution made by entrepreneurship, payment for which is ‘profit’.

Additional Reading: What are the Types of Banking

Circular Flow Of Income In Two Sector Economy

It is defined as the flow of payments and receipts for goods, services and factor services between household and firm sector of the economy.

Circular Flow of Income

Explanation:

  • The outer loop of the diagram shows the flow of factor services from households to firms and the corresponding flow of factor payments from firms to households.  
  • The inner loop shows the flow of goods and services from firms to households and the corresponding flow of consumption expenditure from households to the firm.  
  • The entire amount of money, which is paid by firms as factor payments, is paid back by the factor owners to the firms.

Methods of Calculating National Income

There are three known methods by which national income is determined, and these are:

  1. Value Added Method
  2. Expenditure Method
  3. Income Method

Let us look into the details of each of these methods.

Value Added Method

The value added method is also known as the product method or output method, and its primary objective is calculating the national income by taking into account the value added to a product during the various stages of production.

Therefore, the formula for calculating national income by value added method can be expressed as:

National Income (NI) = ( NDPfc ) + Net factor income from abroad

Expenditure Method

The expenditure method of national income calculation is based on the expenditures taking place in the economy. The expenditures that happen in an economy can be done by individuals, households, business enterprises and government.

Therefore, the formula for calculating national income by expenditure method can be expressed as:

National Income (NI) = C + G + I + (X-M)

Or

National Income (NI) = C + G + I + NX

Income Method

The third method of calculating national income is the income method, and it is based on the income generated by the individuals by providing services to other people in the country either individually or by using assets at disposal.

The income method takes into consideration the income generated from land, capital in the form of rent, interest, wages and profit.

The National income by income method is calculated by adding up the wages, interest earned on capital, profits earned, rent obtained from land and income generated by self-employed in an economy. It is known as Net Domestic Product at Factor Cost or NDPfc.

The addition of Net factor income from abroad to the Net Domestic Product at Factor Cost gives the National Income.

It can be expressed in a formula as :

NNPfc = ( NDPfc ) + Net factor income from abroad

3-4 Marks questions
Q.1-What are the four factors of production and what are the remunerations to each of these called?
Answer:
Explanation
  • Production of goods and services is the result of the combined efforts of the following four factors of production:
  • These are Land, Labour, Capital, and Enterprise.

Factors of production Remuneration

1. Land Rent

2. Labour Wage

3. Capital Interest

4. Enterprise Profit

Q.2 What do you understand by factor income? What are its broad categories?
Answer:
(A)Meaning
  • It refers to the income received by factors of production for rendering factor services in the process of production.

 

(B)Categories
  • Factor incomes are broadly classified into four categories:

Rent, Wages, Interest and Profit.

 

Q.3 Difference between real flow and money flow.
Answer:
Basis Real Flow Money Flow
(a)

Meaning

It is the flow of factor services from households to firms and the flow of goods and services from firms to households. It is the flow of factor payments by firms to households and payment for goods and services by households to firms.
(b) Meduim of Exchange (i) Factors

(ii) Goods & services

Money
(c) Other Name It is also known as Physical flow. It is also known as Nominal flow.

Also know: Difference between Primary and Secondary Market 

Q.4 Define the term ‘flow and stock’
Answer:
Flow ‘Flow’ is a variable measured with reference to a period of time.

Example– Flow of water in a river, Income earned in a year, etc.

Stock ‘Stock’ is a variable measured with reference to a particular point of time.

Example-Water in a tank, Wealth, Bank Balance on 31st March, etc.

Classify the following as stock and flow:

(a) amount of bank deposits as on 31.03.2016 (b) profit

(c) losses (d) capital

(e) production (f) population of india

(a) Amount of bank deposits as on 31.03.2016 ‘Stock’ as these are related to a point of time.
(b) Profit ‘Flow Variable’, as profit is measured over a period of time.
(c) Losses ‘Flow Variable’, as losses are measured over a period of time.
(d) Capital ‘Stock’, as capital is related to a point of time.
(e) Production ‘Flow Variable’, as production is measured over a period of time
(f) Population of India ‘Stock’, as the population is related to a point of time.
1 Mark questions
Define leakage.
Answer:

  • It refers to the withdrawal of money from the circular flow of income.
  • When households and firms save a part of their income, it leads to a leakage from the circular flow of income.
 Define Injections.
Answer:

It refers to the addition to the circular flow of income. For example Borrowings.

Multiple Choice Question:
Q.1- Flow of goods and services between firms and households are__________
a. Real flow

b. Money flow

c. The flow of capital

d. Flow of stock

Q.2- Two-sector economy consists of:
a. Firms and Government

b. Household and Government

c. Household and firms

d. Household and foreign sector

Q.3- Which of the following is the consumption sector?
a. Government

b. Households

c. Firms

d. Foreign sector

Q.4-Which of the following is not a flow?
a. Capital

b. Income

c. Investment

d. Depreciation

Answer Key:
1-a , 2-c , 3-b , 4-a

The above mentioned is the concept that is explained in detail about the Circular Flow of Income and Methods of Calculating National Income. To know more, stay tuned to BYJU’S.

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