Circular Flow of Income and Methods of Calculating National Income

Last Updated : 06 Apr, 2023

Macroeconomics tries to study the central questions of economies. Amongst these questions, the main question is how economies create wealth. In an economy, all factors of production (FoP) undergo a production flow/cycle, in the process of which, it generates wealth in the form of making payments to the factor of production, known as factor payments. Thus, the economic wealth of nations is created by generating this flow and producing commodities (goods and services), which are then consumed by consumers who spend their income on these goods and services.

Circular Flow of Income

The circular flow of income is an economic model that reflects how money or income flows through the different sectors of the economy. A simple economy assumes that there exist only two sectors, i.e., Households and Firms. Households are consumers of goods and services and the owners of the factors of production (land labour, capital, and enterprise). However, the firm sector produces goods and services and sells them to households.

In the circular flow of income (two-sector economy), there is an exchange of goods and services between the two players, i.e. the firms and households, which leads to a certain flow of money in the economy. Households provide the firms with the factors of production, namely, land (natural resources), labour, capital and enterprise that generates goods and services, and consumers spend their income on the consumption of these goods and services. The firms then make factor payments to households in the form of rent, wages, interest and profit. This flow of goods and services and factors payments between firms and households reflects the circular flow of money in an economy.

The circular flow of income in a two-sector economy is the form of a closed economy. The complexity of the model increases as the number of players like government, external trade, and savings are added. It is assumed there's no leakage in this model, i.e. there is no other way in which the income can be disposed of.

A Closed Economy is an economy in which the government sector and foreign trade do not play a role. In other words, an economy in which there does not exist any economic relation with the rest of the world is known as a Closed Economy. However, an Open Economy is an economy where the economic relationship exists between the economy and the rest of the world.

The five assumptions of the circular flow of income in a simple economy (two-sector economy) are as follows:

An economy consists of only two sectors, i.e., Households and Firms, and is a closed economy, which means that there is no government and foreign sector interference.
The household sector supplies the factor services only to the firms, and the firms take factor services only from households.
The firms produce goods and services for the household sector only, and sell their entire production output to the households.
The households receive income, known as factor income for the factor services supplied to the firms and spend the entire income on the consumption of goods and services.
The last assumption is that there are no savings in the economy. In other words, neither the firms save money from their profits, nor do the households save their factor income.

The above figure describes that firm produces goods and services, and households consume them. Households spend their income on the goods and services produced by firms, which ultimately means aggregate consumption by consumers equals aggregate expenditure incurred by firms. On the other hand, firms make factor payments for factor services provided by households in the form of rent, wages or interest. This cycle continues, and over the time it generates national income or aggregate income of an economy. Therefore, aggregate income is nothing but aggregate goods and services produced by the firm.

National Income

National income is the total value of goods and services produced during a financial year in an economy. In other words, it is the total amount of money or income accruing to a country from different economic activities during a financial year. National Income is the most comprehensive measure of an economy's performance and can be calculated by three different methods: Value-added or Product Method, Income Method and Expenditure Method.

Methods of Calculating National Income

National income (NY) can be computed using any of the three below stated methods:

Value added method or Product method
Income method
Expenditure method

Value Added Method/ Product Method

Value Added is a method of calculating the National Income of an economy in different production phases in a circular flow. The production process of a good or service involves different production units. The value added method shows the value added or contribution of such units.

Every enterprise of industry adds some value to a final product, and for its production, it purchases some intermediate goods from other firms. To calculate the National Income of an economy, the value added by each of these individual firms to the final product is summed up. Other names of Value Added Method are Product Method, Inventory Method, Commodity Service Method, Industrial Origin Method and Net Output Method. To calculate the National Income of an economy, first of all, the Gross Value Added is calculated. The formula for calculating Gross Value Added(GVA_MP ) is

GDP_MP = ∑GVA_MP

OR

GDP_MP = GVA_MP of Primary Sector + GVA_MPof Secondary Sector + GVA_MP of Tertiary Sector

The formula for calculating National Income through Value Added Method is

National Income or NNP_FC = GDP_MP - Depreciation - Net Indirect Taxes + NFIA

Income Method

The Income Method calculates the National Income of an economy based on the idea that whatever the firm earns in exchange for goods and services is used to make the factor payments. In other words, to calculate the national income of an economy through the Income Method, the incomes received by residents of a country for the productive services provided by them during a year are added together. The incomes for the productive services or factors of production are received by the residents in the form of profits, wages, interest, rent, etc. Other names for Income Method are Distributive Share Method and Factor Payment Method. The formula for calculating National Income by Income Method is

National Income or NNP_FC = NDP_FC or Domestic Income (Compensation of Employees + Rent and Royalty + Interest + Profit + Mixed Income) + NFIA

Expenditure Method

The Expenditure Method of calculating National Income takes the final expenditures of an economy into consideration. The factor income earned by different factors of production is spent by the different sectors of an economy in the form of expenditure on the purchase of goods and services manufactured by the firms. Under this method, all these final expenditures incurred on the purchase of goods and services by the government, households, foreigners, and business firms are added together. Another name for the Expenditure Method is Income Disposable Method. To calculate the National Income of an economy, first of all, the sum total of all the final expenditures is determined using the formula,

GDP_MP = ∑Final Expenditure

OR

GDP_MP = Private Final Consumption Expenditure (PFCE) + Government Final Consumption Expenditure (GFCE) + Gross Domestic Capital Formation (GDCF) or Domestic Investment + Net Exports (X - M)

The formula for calculating National Income through Expenditure Method is

National Income or NNP_FC = GDP_MP - Depreciation - Net Indirect Taxes + NFIA

Product or Value Added Method of calculating National Income

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Circular Flow of Income and Methods of Calculating National Income