Module 4

National Income Concepts – Methods of measuring – Difficulties in

measurement - Circular flow of income - Two sector and multi-sector
models – (Problems on National Income).
Inflation – Types – Causes – Measures to control – Deflation.
Trade cycles – Money – functions - stock and flow concept - Velocity of
circulation of money - Quantity theory of money - Fischer’s Equation
and Cambridge Equation.
circular flow of income
• The circular flow of income is a fundamental concept in economics
that illustrates the movement of money, goods, and services between
different sectors of the economy
• It describes how income flows between households, firms, the
government, and the foreign sector, highlighting the interdependence
between them.
• the two-sector model explains the basic relationship between
households and firms, showing how households provide factors of
production to firms in exchange for income, and how this income is
used to purchase goods and services from firms.
 Circular Flow in a Two Sector Economy
• simple hypothetical economy where there are only two sectors, the
household and business. The household sector owns all the factors
of production, that is, land, labour and capital. This sector receives
income by selling the services of these factors to the business sector.
• business sector consists of producers who produce products and sell
them to the household sector or consumers. Thus the household
sector buys the output of products of the business sector.
• The Flow:
1. Households provide factors of production (labor, land, capital,
entrepreneurship) to firms.
2. Firms pay income to households in the form of wages, rent, interest,
and profits.
3. Households use this income to buy goods and services from firms,
generating revenue for the firms.
4. Firms produce goods and services using the factors of production,
and the cycle continues

Y= C +I
Circular Flow of Income in the Four-Sector
• The four-sector model includes:
1. Households
2. Firms
3. Government
4. Foreign sector (Rest of the world)
• The Flow:
1. Households provide factors of production and receive
income (like in the two-sector model).
2. Firms produce goods and services, pay households
income, and sell products to households and other
sectors.
3. Government collects taxes from households and firms and
provides public goods and services. It also transfers
payments, such as subsidies and welfare.
4. Foreign sector involves exports and imports. Firms sell
goods to foreign markets (exports) and buy goods from
abroad (imports).
GDPMP=C+G+I+(X−M)
• Comparison of Two-Sector and Four-Sector Models
• The two-sector model is closed and focuses on simple interactions
between households and firms, with no savings, government, or
foreign trade.
• The four-sector model is more realistic, including government actions
(taxes and spending), savings and investment, and international trade
(imports and exports), making it an open economy model.
Differentiate between GDP GNP and NDP
• GDP (Gross Domestic Product) and GNP (Gross National Product) are both
measures of a country's economic performance
• GDP is total market value of all goods and services produced within a country's
borders in a specific time period (usually a year). It only includes income generated
within the domestic economy
• GDP=C+I+G+(X−M)
• GNP is the total market value of all goods and services produced by a
country's residents, regardless of whether the production takes place within
the country or abroad.
• It includes income earned by nationals abroad and excludes income earned by
foreign residents within the country.
• GNP=GDP+NFIA
• NDP is an economic measure that represents the total value of all goods and
services produced within a country's borders in a specific period (usually a
year), after accounting for depreciation.
• NDP=GDP−Depreciation
 methods of national income calculation
Method What it Measures Key Equation
• National income is the total
value of all goods and Production Total value added by NI=∑(Value of Output−Inte
Method each sector (agriculture, rmediate Consumption)
services produced in a manufacturing,
country over a specific services).
period, typically one year.
Income Total income earned by NI=Wages+Rent+Interest+
• There are three primary Method factors of production Profit+Mixed Income+NFI
methods used to calculate (wages, rent, interest, A
national income: the profits).
Production Method (Value
Added Method), the Expenditur Total expenditure on NI= C+I+G+(X−M)
e Method final goods and services
Income Method, and the produced in the
Expenditure Method. economy.
 GDP (Gross Domestic Product) GNP (Gross National Product) NDP (Net Domestic
Feature
Product)
Total value of goods and
Total value of goods and
Definition services produced by a GDP minus depreciation (net
services produced within a
country's residents (domestic of wear and tear on capital).
country's borders.
and abroad).
Domestic production,
Income generated by
Includes regardless of ownership (both Domestic production after
nationals, both domestically
domestic and foreign accounting for depreciation.
and abroad.
producers).

Excludes Income from abroad by Income earned domestically Depreciation (capital

nationals. by foreign residents. consumption).

Relation with NFIA Includes NFIA (Net Factor Depreciation is subtracted

Does not include NFIA.
Income from Abroad). from GDP to calculate NDP.

Formula C+I+G+(X−M) GDP+NFIA GDP−Depreciation

Measures income generated Reflects the net value created

Purpose Measures the overall size of
by a country’s residents by the economy, accounting
a country's economy.
globally. for the loss of capital stock.
Indicator of sustainable
Indicator of domestic Indicator of the total income
Significance production and real economic
economic activity. of a nation’s residents.
What are the difficulties in the measurement
of NI?
• Informal Economy
• Activities such as street vending, unregistered small businesses, and informal labor
contribute to national income but may go unreported.
• Underground Economy
• Illegal activities such as drug trade, smuggling, and unreported income can distort national
income figures if not accounted for.
• Non-Market Transactions
• household labour, volunteer work
• Depreciation Estimation
• Underestimating or overestimating depreciation
• Data Collection Issues
• International Transactions
 Calculation- University Question
• Estimate GDPMP ,GNPMP and • GDPMP (Gross Domestic Product at
National Income. Private Market Prices)
consumption expenditure = • GDPMP=C+G+I+(X−M)
2000 (in 000 crores), • GDPMP=2000+500+800+700=4000
Government consumption =
500, NFIA= -300, • GNPMP (Gross National Product at Market
Investment=800, Net Prices)
• GNPMP=GDPMP+NFIA
exports=700,
• GNPMP=4000+(−300)=3700
Depreciation=400 and Net-
indirect tax=300. • National Income (NI)
• NI=GNPMP−Depreciation−Net Indirect Tax
• NI==3700−400−300=3000
 University question
• From the data given below estimate
the NDP, using income method and
• NDP
expenditure method. Items • NDP=C+I+G+(X−M)−Depreciation
(Rs .Crores) • expenditure method.
• Consumption expenditure 3000 • GDP=3000+2000+700+(600−300)=6000
Investment expenditure 2000 • Income Method
Government expenditure 700
• The income method calculates NDP by
• Exports 600 summing up all factor incomes generated
• Import 300 within the economy.
• Intermediate Consumption 2000 • NDP=Wages and Salaries+Rent+Interest+Profit
+(Indirect Taxes−Subsidies)−Depreciation
• Wages and salaries 2000 • NDP at Factor Cost=2000+500+500+1000=4000
• Rent 500
• Interest 500
• Profit 1000
 Inflation
• It is the persistent increase in general price level or persistent decline in the real income
of the people.
• Inflation refers to the rate at which the general level of prices for goods and services
rises, eroding purchasing power over time.
• It means as the price rises, the value of money declines
• “Too much money chasing too few goods”
• Inflation is typically measured as an annual percentage change in a price index, such as
the Consumer Price Index (CPI)
• A positive inflation rate indicates that prices are increasing, while a negative inflation
rate (deflation) signifies that prices are falling.
• Creeping inflation > 0 – 3 %
• Walking inflation > 3 – 10 %
• Galloping inflation > More than 10%
• Hyper inflation > More than 50%
 Causes or types of Inflation
• Demand-Pull Inflation: Occurs
when aggregate demand in an
economy outpaces aggregate
supply. This can happen during
periods of economic growth when
consumer confidence is high,
leading to increased spending.
• Cost-Push Inflation: Results from
rising production costs, such as
increased wages and raw material
prices. Businesses pass these
costs onto consumers in the form
of higher prices.
Methods to control Inflation
• Monetary Policy
• Interest Rate Adjustments: Central banks, such as the Reserve Bank of India,
can increase interest rates to curb inflation. Higher interest rates make
borrowing more expensive, reducing consumer and business spending, which
can help lower demand and stabilize prices.
• Open Market Operations: Central banks can sell government securities to
absorb excess liquidity from the market. This action reduces the money
supply, leading to higher interest rates and lower inflation.
• Reserve Requirements: By raising the reserve requirements for commercial
banks, central banks can limit the amount of money banks can lend, thus
reducing the money supply and controlling inflation.
Fiscal policy
• Government Spending: Reducing government expenditure can help
cool down an overheating economy. Cutting public spending on non-
essential projects can decrease overall demand in the economy.
• Taxation: Increasing taxes can reduce disposable income for
consumers and businesses, leading to lower spending. This decrease
in demand can help control inflation.