National Income Concepts

Section 1: Circular flow of income in an open economy

Let us first understand the meaning of the term “open economy”. In a nutshell, an open economy is
an economy that trades with other economies, while a closed economy is an economy where trade
happens only within the geographical boundaries of the country. It is rare for a country to be fully
closed. Open economies are very common in the modern world, though the degree of openness varies
across different countries1.

The economic players in an open economy can be broadly divided into four categories:

a) Households
b) Firms
c) Government
d) Rest of the World with whom this country engages in trade in goods and services.

It is important that we distinguish between stocks and flows when studying the macroeconomy. A
flow variable is a variable that is measured per unit of time. Income, for example, is a flow variable
because we talk about income per month, income per day, income per year and so. Wealth, on the
other hand, is an example of a stock variable. Another example of a stock variable is the stock of
money in the economy in a given year. The number of educated people in the country is a stock
variable. On the other hand, the country’s exports in a given year is a flow variable. Any variable, that
is expressed per unit of time, is a flow variable.

In what way can we characterise the flow of income in an open economy?

The diagram below illustrates this quite well:

1
A country’s degree of openness can be measured by the “Open-ness Index”, which is the ratio of the value of
imports + exports in a given year to the country’s GDP in that year.
Households earn income through supplying various goods and services to the other three players, and
earn an income in return. They either save this income with financial institutions or consume it by
purchasing from domestic firms, paying taxes to the government, or importing goods and services
from the rest of the world. The amount that households save with financial institutions can be lent to
firms or the government . The rest of the world earns incomes from exports to our country. It also
imports from our economy. When the rest of the world buys from our firms, our firms earn an income
in addition to what they earn through the consumption expenditure of households. Our firms also
earn an income when the government purchases their products while firms spend some of their
incomes paying taxes to the government. Households too, spend a portion of their incomes for paying
taxes to the government. The Government in turn makes some transfers to households. The total
amount spent by the various entities (firms, households, governments and the rest of the world) must
be equal to the total incomes earned by all the entities put together. This is called the circular flow of
income in an open economy.

Total expenditure by various entities in the economy is an injection into the circular flow of income,
whereas total withdrawals from expenditure are leakages. Household expenditure on goods and
services of domestic firms + expenditure by domestic firms on purchasing goods and services from
households + investments by firms+ transfers by the governments to the other two entities + income
earned from selling to the rest of the world gives the total injections into the circular flow of incomes.
Savings by households and firms + taxes by the government + amount spent on buying from the rest
of the world constitute leakages from the circular flow of income.

Components of GDP

Let us think about GDP from expenditure point of view. Who are all of the players that might have
spent money on final goods and services produced in our country? The national income accounts
divide GDP into four broad categories of spending. In other words total demand for domestic output
is made up of four components.

• Consumption spending by households(C)

• Investment spending by business and households(I)
• Government (federal, state and local) purchases of goods and services (G)
• Foreign demand for our net exports (NX)

The entire relation can be simplified into the following equation:

𝒀 = 𝑪 + 𝑰 + 𝑮 + 𝑵𝑿

GDP is the sum of consumption, investment, government purchases, and net exports.

Consumption consists of goods and services purchased by households. It is divided into three
subcategories: nondurable goods, durable goods, and services. Nondurable goods are goods that last
only for a short period of time such as fruits. Durable goods are goods that last for a long time, such
as furniture. Services include the work done for consumers by individuals and firms, such as services
rendered by teacher.

Investment: The term investment is already defined in previous section. Investment includes housing
construction, building of machinery, construction of factories and offices, and additions to a firm’s
inventories of goods.

Government purchases are the goods and services purchased by the federal, state and local
governments. This category includes such as national defence expenditure, cost incurred in the
construction of highways, and salaries of government employees. We refer to government spending
on goods and services as purchases of goods and services. In addition, the government makes transfer
payments. These are mainly welfare payments such as subsidies on food and fertilizers, social security
benefits. Transfer payments are not counted as part of GDP because transfers are simple
redistribution of income – the government collects tax from some people and redistribute to others.

Net exports are the value of goods and services sold to other countries (exports) minus the value of
goods and services that foreigners sell us (imports). Net exports are positive when the value of our
exports is greater than the value of our imports. Net exports provide income to our domestic
producers.

How does one measure the size of the circular flow? This will require us to ask each individual, firm,
exporter and government to tell us how much they earned and add everything up to get a sense of
the total income in an economy. Of course, in a real economy, this can never be done perfectly. Many
individuals and firms do not reveal their incomes fully, or under-report their incomes. For example, a
labourer who gets Rs. 200 for helping out with repairing a road may not report this earning to anybody.
An eminent surgeon might not reveal the amount that he gets for carrying out surgeries so as to avoid
paying taxes. Manufacturing units may understate production in order to avoid excise duties.

Then, there is a host of activities that are clearly illegal. For example, since betting on cricket is illegal
in India, it is not possible to know the incomes generated in this business. We cannot also estimate
incomes generated from activities like smuggling, illegal construction, drug trafficking, poaching of
animals, extortion etc., even when incomes are actually generated in such activities.

In addition, and probably the most important, are the activities that cannot be measured since they
are not channelled through the market mechanism. A good or service might be actually produced in
the economy, but since nobody pays for it, no actual monetary income may be generated. Suppose I
start teaching students free of cost. A service is being generated, there is surely some output, but it
cannot be counted since actual income is not being generated. However, if somebody starts to pay
me for doing this, an income will be generated and the activity can be counted. If I do my own typing,
no income is generated, even though an output is being generated. If I hire a typist to do this and pay
her for the service, it will of course be counted.

Activity 1:
List out five activities around you where goods and services
are produced, but incomes are not generated. What will be
the impact on total incomes if these activities started to
generate an actual income?

In spite of these limitations, it is important to measure the level of income in any country. Measuring
the level of income gives us a rough and partial idea of the level of well-being of that country. That is
where the concept of the Gross Domestic Product (GDP ) of a country comes in. The GDP of a country
is the market value of the final goods and services produced in the country in a given year. It includes
the value of goods produced, such as houses and fans, and the services, such as services rendered by
the doctor. The output of each of these is valued at market price and the values are added together
to get GDP.

The operative words here are final, within the country, and in a given year. Why final? Suppose our
country just produces on product, say bread. The farmer grows the wheat (Let us assume that he does
it costlessly) and sells it to a trader for Rs. 10. The trader sells it to a flour mill for Rs. 12. The flour mill
converts the wheat into flour and sells it to a baker for Rs. 15. The baker makes bread out of it and
sells it as a finished product for Rs. 17. The value of the final product is thus Rs. 17. How is it related
to the total incomes produced in the country? The income earned by the farmer is rs.10 ( since he did
not spend anything on producing the wheat). The trader earned Rs. 2 by buying it from the farmer for
Rs 10 and selling it to the flour mill owner for Rs. 12, the flour mill owner earned Rs. 3 and the baker
finally earned Rs. 2. All these earnings at various stages are called “value added”. The total value added
in the economy = Rs. 10 (farmer) + Rs. 2 (trader) + Rs.3 (flour mill owner) + Rs. 2 (baker) = Rs.17, exactly
the final value of the bread produced. Rs. 10 is the farmers’ contribution to the total output. The
contribution of the trader is Rs. 2. The contribution of each of the agents in this change is called “value
added”. The wheat produced by the farmer that went into making of the flour and the flour that went
into making the bread are all referred to as “intermediate inputs”. Intermediate inputs are those
goods and services that are used up in the production of other goods and services during the same
period in which it was produced.
Activity 2:

a) Consider a country where production of ice-cream is the

only economic activity. Suppose producing milk costs 10 Rs
litre and 100 liters of milk are produced. This milk is bought by
a milk-processing company, pasteurised, packaged and sold to
an ice-cream manufacturer for Rs. 15 per litre. The ice-cream
manufacturer produces ice-cream and sells it to an ice-cream
selling outlet for Rs. 17 per litre. Finally, the ice-cream selling
outlet sells the ice cream to the final consumer for Rs. 20 per
litre. Calculate the value added at each stage and also the total
GDP of this country.

b) Consider your household as a production unit. What are the

intermediate inputs and final products of your household? Are
there any goods and services that are produced by your
household for which no incomes are generated?

Activity 3:
 Manish’s mother used to help him study after school.
However, because she was busy looking after his baby
brother when Manish was in the 9th standard, his parents
hired a teacher to help him instead of his mother. Discuss
how this would affect measured income in the country.

Now suppose, the baker does not sell all is bread in the same time period as that in which it was
produced. This will be used in the next period and is called “inventory investment”. A farmer may
store some of his wheat produced in a year to be used as seed in the next year. This is another example
of inventory investment. This is reported as output in the form of inventory. Suppose the farmer buys
a tractor. The tractor is not a final good, nor is it an intermediate good since it is not used up in the
production of the food grains in the same year. The tractor is used to produce another good, but unlike
an intermediate product, it is not used up entirely in the same period of production. Such goods are
called capital goods. Suppose a cobbler buys an anvil to produce shoes. The anvil is an input into
production of shoes, but it is not used up in the same accounting period. Hence, it is a capital good.
On the other hand, the leather that the cobbler uses to make shoes is an “intermediate input”.
However, one must be very careful when one talks about investment for the economy as a whole.
What looks like investment for an individual need not be investment for the economy as a whole. For
example, if the painter in our example has merely brought his brush from another painter, the
aggregate of capital goods produced in the country has not increased. Capital goods have simply been
reallocated from one individual to another.
Activity 4:

a) Suppose a painter uses paint, brushes, thinner and a

ladder to paint a wall. Which of these inputs are capital
goods, and which are intermediate inputs?
b) I am writing a book. I use pen, paper, ink, a lamp, a table
and a chair. What is the final product of this activity?
Which inputs are intermediate inputs and which are
capital goods?

Think of the painter in activity 4. His brush is a capital good. It is not fully uses up in the same
accounting period. However it wears out over time. This wear and tear of capital goods is referred to
as “depreciation”. You can think of depreciation as an intermediate input produced by the capital
good.

If the painter buys a new brush worth Rs. 500, then he has bought a new capital good and made a
gross investment of Rs.500. However, if his old brush has undergone depreciation worth Rs. 100, then
his net investment is Rs. 500 – Rs. 100, or Rs. 400. Net investment in a particular time period equals
gross investment in that time period minus deprecation incurred in that time period.

There is also the issue of imputations. People who do not stay in their own houses do not pay a rent
to themselves. Yet, a stream of housing services are produced because they are using the houses. In
such cases, the authorities impute a value to these services in the calculation of GDP. Similarly, the
government produces many services., say defence. Since there is no market price for defence, you
cannot find its value. In such cases, the value of the services produced by this sector is calculated at
the cost of providing these services. Hence, the total government expenditure on public
administration will be counted as the value of the services produced by public administration.
Activity 5:

a) Visit you college canteen and measure the total value of

goods and services produced during a day. What are the
various inputs that your college canteen uses? Which
one of them are intermediate inputs? Which one of
them are capital goods? What constitutes inventory?
Are there any inputs into production that do not have a
market value? Discuss these in class.
b) The implementation of the 7th Pay Commission has
increased the salaries of government officials in 2016.
What effect does this have on GDP calculations?

So now , we can think of the aggregate output of all private units. To obtain this sum, we must
first add the value added that is produced by all private entities like households and firms in
the production of final goods including the value of capital goods and inventories and then
subtract depreciation from this sum. If we add to the aggregate output of all private units the
output produced by the government, we will get the total value of output produced in the
country in a given year. But one must remember that the measure that we get by doing this
is only an imperfect measure of the total value of goods and services produced in the country
in that year.

Other Measures of Income

Remember, GDP measures the aggregate value of final goods and services produced in the
country in a given year. But some of this output may actually have been sold abroad,
generating incomes for the entities in this country. Similarly, the entities in this country may
have bought goods and services that were produce in foreign countries, thereby transferring
some incomes for them.

The national income accounts include other measures of income that differ slightly in
definition from GDP. We start with GDP and subtract or add various quantities. Let us begin
with gross national product (GNP). To obtain GNP, we add receipts of factor income (wages,
profit and rent) from the rest of the world and subtract payments of factor income to the rest
of the world.

𝑮𝑵𝑷 = 𝑮𝑫𝑷 + 𝑭𝒂𝒄𝒕𝒐𝒓 𝑷𝒂𝒚𝒎𝒆𝒏𝒕𝒔 𝒇𝒓𝒐𝒎 𝑨𝒃𝒓𝒐𝒂𝒅

− 𝑭𝒂𝒄𝒕𝒐𝒓 𝒑𝒂𝒚𝒎𝒆𝒏𝒕 𝒕𝒐 𝑨𝒃𝒓𝒐𝒂𝒅

The difference between factor payments from abroad and factor payment to abroad is called
Net Factor Incomes from Abroad. GDP measures the total income produced domestically,
GNP measures the total income earned by nationals (residents of a nation). The difference
between the two measures is based on the citizenship. GDP is the output produced within a
country’s borders irrespective of whether or not it is produced by citizens of a country while
GNP is the output produced by a country’s citizen regardless of where in the world they work.
For instance, if Indian citizen owns apartment in England, the rental income he earns is a part
of England’s GDP because it is earned in England. But his rental income is a factor payment to
abroad, it is not part of England’s GNP. Similarly, income of an Indian citizen working in U.S is
a part of India’s GNP but not part of India’s GDP because it is not earned in India.

But Gross National Product (GNP) doesn’t measure actual productive capacity of the country.
This is because, while we are producing commodities and services, there is some wear and
tear, or depreciation of the capital stock which is used for production of goods and services.
Hence, we must adjust GNP for this depreciation. When you subtract depreciation from GNP,
you get Net National Product (NNP)

NNP = GNP - deprecation

Again, one must remember that what we have is the market value of goods and services produced in
the country and net incomes from abroad. The market value is computed at current market prices.
When one sells an apple for example for 10 Rs, the seller does not get the entire 10 Rs as his income.
Some amount has to be paid as indirect taxes like sales tax. When we want to calculate the actual
income received by the seller, we have to add subsidies received and subtract the indirect taxes paid.
That gives us the next relationship:

National Income= NNP + Subsidies - Indirect Taxes

Activity 6:

Suppose a country produces 5 kgs of apples and three

dozen bananas in a year as its only output. The price of
apples is Rs 100 per kg and the price of bananas is Rs. 20
per dozen. The cost of intermediate inputs into
production of both is Rs.50. The country sells apples
worth Rs. 50 to its neighbouring country and buys
tomatoes worth Rs 40 from the neighbour. The indirect
taxes paid are Rs.30, while depreciation is Rs.10.
Calculate:
1. GDP of the country
2. GNP of the country
3. NNP of the country
4. National Income of the country
Nominal and Real GDP
Suppose a country produces 20 kg of rice and 10 kg of wheat in a year in the year 2015. Suppose the
price of rice in 2015 is Rs. 10 per kg while the price of wheat is Rs. 20 per kg. The total GDP of the
country in 2015 is then

(Output of rice in kg multiplied by price per kg of rice) + (Output of wheat in kg multiplied by the price
per kg of wheat ) = 20 kg * 10 per kg + 10 kg * 20rs per kg

=200 Rs + 200 Rs = 400 Rs.

Now suppose in 2016, the output of rice becomes 22 kgs and the price rises to 15 Rs per kg while the
output of wheat increases to 13 kgs and the price rises to 25 Rs per kg. Then, the GDP of the country
in 2016 is

Output of rice in kg in 2016 multiplied by the price of rice per kg in 2016 + Output of wheat per kg in
2016 multiplied by the price of wheat per kg in 2016 =

22 multiplied by 15 + 13 multiplied by 25

= Rs. 655.

How much has GDP increased over the year? This can be calculated as follows:

Percentage GDP growth from 2015 to 2016 = ((GDP in 2016-GDP in 2015)/GDP in 2015 )*100

=((655-400)/400)*100 = 63.75%.

However, this does not mean that real output has increased by 63.75%. At least a part of the increase
has been because prices of wheat and rice have also increased from 2015 to 2016. So, if we want to
focus only on the real rise in output, we should eliminate the effect of the price rise. This can be done
by measuring the GDP in 2016 by assuming that the prices remained the same as in 2015. This measure
of GDP is referred to as GDP at constant prices or real GDP, while the previous measure of GDP is
called GDP at current prices or the nominal GDP. So, real GDP or GDP at constant prices in 2016 will
be

GDP at constant prices in 2016 = (Output of rice in 2016 * price of rice in 2015 )+ (Output of wheat in
2016*price of wheat in 2015)

= (22 kgs *Rs. 10 per kg )+(13 kgs * Rs.20 per kg)

=Rs 220 + Rs 260

=Rs. 480

Now, if calculate the growth in GDP over the two years, it would be

((480-400)/400)*100

=20%.

So, the growth in output, that is the growth of real GDP, has been much smaller than the growth in
nominal GDP. This is because a part of the growth in nominal GDP is happening because of the price
increase over the two years.

If we divide the nominal GDP in a given year by the real GDP for that year, we get what is called the
GDP deflator. The GDP deflator gives us an idea of the overall price level (rather than prices for
particular commodities) that any economy faces. In our example, the GDP deflator for 2016 is given
by

GDP deflator for 2015 = ( Nominal GDP for 2016)/ (real GDP for 2016)

=655/480

=1.36

This means that if we regard the overall price level in 2015 to have been 1, the overall price level is
1.36 in 2016. The price aggregate price level faced by the economy has risen by 36% between the two
years.

Activity 7:

A country produces 10 kgs of rice, 10 kgs of wheat, 20 liters

of milk and 15 haircuts in 2015. The price of rice is 20 Rs a kg,
the price of wheat is Rs. 30 a kg, a liter of milk costs 40 Rs
while a haircut costs 20 Rs in 2015. In 2016, the same country
produces 12 kgs of rice at Rs. 25 per kg, 2 kgs of wheat at Rs.
40 per kg, 60 litres of milk at Rs. 30 a liter and 6 haircuts for
Rs. 3 a haircut.
 a) Calculate the nominal GDP ( or GDP at current prices) for
2015 and 2016
b) Calculate the real GDP (or GDP at 2015 prices ) for the
year 2016
c) Calculate the growth rate of nominal and real GDP for
2016 over 2015
d) Calculate the price deflator. What has been the annual
increase in prices in this country based on the GDP
deflator?

GDP in India

Measurement of GDP in India:

The Central Statistical Office (CSO) of the Government of India calculates the GDP in India. The GDP
data in India are calculated every quarter, that is four times in a year. The first quarter (Q1) is from
April-June, the second quarter (Q2) is from July-September, the third Quarter (Q3) is from October-
December while the fourth quarter (Q4) is from January to March. The methodology for calculating
GDP in India underwent a significant change in 2013-14, so the figures for the previous years are no
longer comparable to the figures for the later years.

There are eight subheads under which GDP is presented. They are as follows:

1. Agriculture

The data under agriculture include more than agriculture. They include “agriculture, forestry and
fishing”. While the crop production data is sourced from the advance estimates released by the
Ministry of Agriculture from time to time, fishing data is taken from the Directorates of fisheries
in each state. Forestry data comprises of industrial wood, fuel wood and minor forest products
such as bamboo, fodder, honey and tendu leaves. Crops including fruits and vegetables account
for 61% of the agriculture sector, while livestock products contribute another 39%.

2. Mining and Quarrying

The activities covered in this sector comprise extraction of minerals which occur in nature as
solids, liquids or gases; underground and surface mines, quarries and oil wells. This data is now
mostly sourced from the financial statements of the companies in the stock market and the
Ministry of Corporate Affairs.

3. Manufacturing:

Manufacturing activities are classified into organized and unorganized for the purpose of
estimation. The private corporate sector growth which has a share of around 69% in the
manufacturing sector is estimated from available data of listed companies with the BSE and NSE.
The quasi corporate and unorganized segment having a share of around 25% in the manufacturing
sector is estimated using the manufacturing data from the index of industrial production (IIP). The
rest 6% is presumably contributed by public sector enterprise.

4. Electricity, Gas , Water supply and Other Utilities

The electricity data is sourced from the IIP released by the CSO every month, while data for gas,
water supply and other utility services, including waste management services, is mostly sourced
from the corporate sector.

5. Construction

Construction data is not collected directly but from key indicators of the construction sector, such
as production of cement and consumption of finished steel. However, under the new series, data
from the ministry of corporate affairs’ website for private sector companies also supplements this.

6. Trade, Hotels, Transport and Services related to broadcasting

The consumption level in the economy is reflected by this segment of GDP. The key indicator used
for estimating the trade sector is sales tax growth. Growth in the hotels and restaurant sector is
estimated from available data from listed private companies. Data from road, railways, airlines
and shipping sectors are used for calculating the transport sector. Communication and services
related to broadcasting includes data from the postal department, telecommunication companies
and recording, publishing and broadcasting companies.

7. Financial , Insurance, Real Estate and Professional Services

A major component of this industry is real estate and professional services, which have a share of
71%. The key source of data for this sector is the quarterly growth of the corporate sector for
computer-related activities which is estimated from available data from listed companies. For the
banking sector, aggregate bank deposits and bank credits are sourced from the Reserve Bank of
India (RBI). For the insurance sector, data from the Ministry of Corporate Affairs website,
Employees’ Provident Fund Organisation (EPFO) and Employees’ State Insurance, among others,
is used.

8. Public Administration, defence and Other Services

This is a proxy for government expenditure, at the levels of the Centre, state and local bodies and
most of the data is sourced from budget documents and regular data released by the Controller
General of Accounts.