What is Circular Flow of Income?
The circular flow means the unending flow 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 payment for the contribution made by fixed natural resources (called land) is known as rent.
- The payment for the contribution made by a human worker is known as wage.
- The payment for the contribution made by capital is known as interest.
- The payment for the contribution made by entrepreneurship is known as profit.
Additional Reading: What are the Types of Banking
Circular Flow of Income in a Two-Sector Economy
It is defined as the flow of payments and receipts for goods, services, and factor services between the households and the firm sectors of the economy.
- 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 firms.
- 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. These are:
- Value added method
- Expenditure method
- 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. Its primary objective is to calculate national income by taking the value added to a product during the various stages of production into account.
Therefore, the formula for calculating the national income by the value added method can be expressed as:
National income (NI) = (NDPfc) + Net factor income from abroad
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 the government.
Therefore, the formula for calculating the national income by the expenditure method can be expressed as:
National income (NI) = C + G + I + (X – M)
National income (NI) = C + G + I + NX
The third method to calculate national income is the income method. It is based on the income generated by the individuals by providing services to the other people in the country either individually or by using the assets at disposal.
The income method takes the income generated from land, capital in the form of rent, interest, wages and profit into consideration.
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 the self-employed people in an economy. It is known as net domestic product at factor cost or NDPfc.
The addition of the 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 known as?|
|Explanation||● The production of goods and services is the result of the combined efforts of the following four factors of production:
● 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?|
|(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. They are:
Rent, wages, interest, and profit.
|Q.3. Differentiate real flow and money flow.|
|Basis||Real Flow||Money Flow|
|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 the payment for goods and services by households to firms.|
|(b) Medium of exchange||(i) Factors
(ii) Goods and services
|(c) Other name||It is also known as physical flow.||It is also known as nominal flow.|
|Q.4. Define the term ‘flow and stock’.|
|Flow||‘Flow’ is a variable that is 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 that is 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 the profit is measured over a period of time.|
|(c) Losses||‘Flow variable’, as the losses are measured over a period of time.|
|(d) Capital||‘Stock’, as the capital is related to a point of time.|
|(e) Production||‘Flow variable’, as the 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|
● 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.
It refers to the addition to the circular flow of income. Example: borrowings
|Multiple choice questions|
|Q.1. The 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. Which of these belong to a two-sector economy?|
|a. Firms and government
b. Households and government
c. Households and firms
d. Households and foreign sectors
|Q.3. Which of the following is the consumption sector?|
d. Foreign sectors
|Q.4. Which of the following is not a flow?|
|1-a, 2-c, 3-b, 4-a|
The above-mentioned concept is explained in detail about the Circular Flow of Income and Methods of Calculating National Income. To know more, stay tuned to our website.