CIRCULAR FLOW AND BASIC AGGREGATES

CIRCULAR FLOW OF INCOME: MEANING

It refers to the cycle of generation of Income in the production process. It’s distribution among the
factors of production and finally, from household to firms in the form of consumption expenditure on
the goods and service produced by these units (it is a continuous process due to the never ending
human wants)

PRODUCTION PHASE

EXPENDITURE PHASE INCOME PHASE

1. In Production Phase, the firm produces goods and services with the help of factor services
2. Under Income Phase, the income (Rent, Wages, Interest, Profit) flows from firms to households
3. In Expenditure Phase, the income received by the household is spent by them on goods and services
produced by the firm

Note: > Factors of Production- Land, Labour, Capital and Entrepreneur.

TYPES OF CIRCULAR FLOW > REAL FLOW & MONEY FLOW

BASIS REAL FLOW MONEY FLOW

MEANING It refers to the flow of factor services from It refers to the flow of factor payments from
households to firms and the corresponding firms to households and the corresponding
flow of goods and services from firms to flow of consumption expenditure from
households. households to firms for purchase of goods
and services produced by the firms.
KINDS OF It involves exchange of goods and services It involves exchange of money.
EXCHANGE

Difficulty In May be difficult No such difficulty

Exchange

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Alternate Physical Flow Nominal Flow
Name

Factor Services Consumption Expenditure

HOUSEHOLD FIRM HOUSEHOLD FIRM

Goods & Services Factor Payments

CIRCULAR FLOW OF INCOME IN A SIMPLE ECONOMY (TWO SECTOR ECONOMY)

Consumption Expenditure

Factor services such as

(Land, Labour, Capital,
Household Entrepreneur) Firm

Goods and Services

Factors payment (Rent, wages, Interest, Profit)

EXPLANATION:
1) It is assumed that there are only two sectors i.e. the households and firm.
2) Households provide factor services to firm and firm provides goods and services back to
households.
3) The firm gives factor payment to the household for the factor services provided by them and
households provide consumption expenditure to the firm for the goods and services consumed by
them.
4) It is assumed that here are no savings in the economy that is neither the firm save from the profit
nor the household save from their income.
5) Outer Loop= Money Flow
6) Inner Loop= Real Flow

STOCK VS FLOW

STOCK FLOW

It refers to that variable which ismeasured at a It refers to a variable which is measured over a
particular point of time. period of time.

It does not have time dimension. It has time dimension.

It is a static concept. It is a dynamic concept.
Eg: Population of India on 31.3.2019 and Eg: No. of births during 2017

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 Stock of enterprise on 31.3.2019 No. of cars sold in March

LEAKAGES VS INJECTIONS

LEAKAGES INJECTIONS

It refers to the withdrawal of money It refers to the introduction of money in circular

from circular flow Flow
When household or firm saves a part of When household or firm borrows from some
their income it leads to a leakage in the External sources such as financial institutions it
circular flow of income add to their income
Leakages refer to the decrease in level of Injection refer to the addition in level of demand
demand which leads to lower level of Which leads to higher level of output in an
output in an economy economy.
Leakages reduces flow of income injections increases flow of income

Examples

TWO SECTOR ECONOMY (W/O No Leakage No Injections

FINANCIAL MARKET)
TWO SECTOR ECONOMY (WITH Savings Investment
FINANCIAL MARKET)
THREE SECTOR ECONOMY Savings + Taxes Investment + Govt.
Expenditure

Note: Equilibrium in an economy is achieved when Injection = Leakages

Extra Discussions:

1. Classify the following as stock and flow:

- Losses
- Savings
- Capital
- Balance in a bank account
- Wealth
- Capital Formation

2. “Circular flow of income in a two sector economy is based on the axiom that one’s expenditure is
other’s income”. Do you agree with the given statement?

- Yes, the given statement is correct. In a two sector economy, the firms produce goods and services
and make factor payments to the households. The factor income earned by the households will be
used to buy the goods and services which would be equal to income of firms. The aggregate
consumption expenditure by the households in the economy is equal to the aggregate expenditure
on goods and services produced by the firms in the economy.

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BASIC CONCEPTS OF MACRO ECONOMICS
1. DOMESTIC TERRITORY (ECONOMIC TERRITORY):
“Domestic territory means the political frontiers/borders of a country”.

According to the United Nations, “Domestic Territory is the geographical territory administered by the
government within which persons, goods and capital circulates freely.

- It also includes-
• Ships and Aircrafts owned and operated by normal residents between two or more countries.
Eg. Planes of Air India operating between Russia and Japan are a part of the domestic country of India.
• Fishing vessels, oil and natural gas rigs and floating platforms operated by residents of a country in
theInternational water.
• Embassies, consulates and military establishments of a country located abroad.
Eg. Indian Embassy in USA

It does not include-

• Embassies, consulates and military establishments of a foreign

country.Eg. Pakistan Embassy in India (Bajranji Bhaijaan)
• International Organizations like UNO, WHO etc. located within the geographical boundaries of
a Country.

2. Normal Residents:
Normal residents of a country refers to an individual or an institution who:

Ordinarily resides in the country Whose centre of economic interest

&
also lies in that country

1. The resident lives or is located within

the domestic territory; and
For a period of more than 1 year 2. The resident carries out basic economic
activities from that location
Note: Following are not included under the category of Normal Residents:

- Foreign tourists and visitors

- Foreign staff of embassies, officials, diplomats and members of the armed forces of a foreign
country.
- International Organizations.
- Employees of International Organizations except, if the employees are working for more than
one year then they become the normal resident of a county in which such institutions are
located.

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 - Crew members of foreign vessels.
3. CITIZENSHIP:
Legal Concept based on 2 elements:
- On the place of birth OR
- By some legal provisions allowing a person to become a citizen

It does not include-

• Foreign Tourists and visitors

• International Organizations
• Foreign Staff of embassies located in the given country
• Employees of the international organization are considered as residents of the country to which
it belongs.
4.
5. FACTOR INCOME & TRANSFER INCOME

BASIS FACTOR INCOME TRANSFER INCOME

MEANING It refers to income received by providing It refers to income received without rendering
factor service in the production process. any productive service in return.
NATURE It is included in both national and domestic It is neither included in national nor in domestic
income. income.
CONCEPT It is earning concept. It is receipt concept.
EXAMPLES Eg: Rent, wages, salary, profit Eg: Scholarship, old age pension.

Note: Taxes received by the government are transfer incomes as they are received without providing any
productive service in return. Similarly, subsidies paid by the government are transfer payments.

6. FINAL GOODS & INTERMEDIATE GOODS

BASIS FINAL GOODS INTERMEDIATE GOODS

MEANING Final goods refer to those goods which Intermediate goods refers to those good which
are used either in consumption or for are used for reselling or further production in
investments. the same year.
NATURE They are included in both national and They are not included either in national or in
domestic income. domestic income.
VAUE They are ready for use by their final users. They are not ready for use.
ADDITION
PRODUCTION They are out of production boundary. They are within the production boundary.
BOUNDARY
EXAMPLES Eg: Milk purchase by households for Eg: Milk used by firm for resale.
consumption.
Notes:

1. National Income includes only final goods

2. Goods used in the same year are Intermediate Goods.
3. Laptop can be both as a final good or an intermediate goods, what matters is its end use.
4. “Machine” purchased is always a final good”. Defend or Refute (SP 2012)

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 Ohh !
7. CONSUMPTION GOODS AND CAPITAL GOODS That’s why it was said
Final Goods are those
used for consumption
or for investment

FINAL GOODS

CONSUMPTION CAPITAL GOODS

GOODS

Refers to Goods Refers to Goods

which satisfy the which help in the
wants of the production of other
consumers directly goods and services

Eg : Plant, Machinery

Durable Goods Semi Durable Goods Non- Durable Goods Services

Goods which are Goods which are Goods which are Non-material goods
used again and again used for a limited used up in a single which directly satisfy
over a considerable period of time. act of consumption. the human wants.
period of time (Around 1 yr)
Eg : Milk, Bread Eg Doctors. Teachers
Eg : TV, Refrigerator Eg : Clothes, shoes

Note: All Producer Goods are not Capital Goods- Producer Goods are those goods which are used in
the production of other goods. All goods used by producer are not capital goods. Producer goods
include two types of goods:

- Single- Use Producer Goods: Cannot be repeatedly used in the production process.

- Capital Goods: It includes fixed assets like plant and machinery, which can be repeatedly used in
the production process.

So, it can be said that all capital goods are producer goods, but all producer goods are not capital
goods.

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 3 ESSENTIAL CONCEPTS
A.
DEPRECIATION
GROSS VALUE It refers to a fall in NET VALUE
the value of fixed
The Value of the The present and actual value
assets due to
commodity atthe time of ofthe commodity
normal wear and
its purchase. E.g.: The Iphone after two
tear, passage of
E.g.: I bought an Iphone yearswas sold for Rs. 40000/-
time or expected
11 forRs.64900 today. Hence Net Value- Rs. 40000/-
obsolescence
Hence Gross Value – Rs. 64900/-
(change in tech)

Gross Value

(+) Depn (-) Depn

Net VALUE

NOTE:

➢ Depreciation is also known as Current Replacement Cost, Replacement Cost of Fixed Capital, Capital
Consumption Allowance.
➢ Depreciation is not same as capital loss (unforeseen obsolescence, natural calamity, unexpected
obsolescence.)
Expected Obsolescence occurs due to change in Unexpected Obsolescence occurs due to natural
technology or change in demand for goods and calamities or due to thefts, accidents etc.
services.

B. NIT= NET INDIRECT TAX

NIT= INDIRECT TAX - SUBSIDIES

FACTOR VALUE

(-) NIT (+) NIT

MARKET VALUE

➢ Indirect Taxes: Taxes imposed by the govt. on the production and sale of goods and services. Eg: GST/Excise
➢ Subsidy: Financial Assistance given by govt. to an enterprise on the production of certain goods and services.
➢ Factor Cost: Amount paid to the FOP for their contribution in the production process.

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➢ Market Price: Price at which the product is actually sold in the market.
C. NFIA= NET FACTOR INCOME FROM ABROAD

NFIA = FACTOR INCOME EARNED FROM ABROAD – FACTOR INCOME PAID ABROAD

FIFA FITA

Is the income earned by normal Is the factor income paid to the

residents of a country from Rest of normal residents of other countries
the World in the form of wages and (NR) for their factor services within
salaries, rent, interest, dividend and the economic territory.
retained earnings.

NATIONAL

(+) NFIA (-) NFIA

DOMESTIC

So, National Income = Domestic Income + FIFA – FITA (NFIA)

NFIA can be: -

- Positive (Received > Paid)

- Negative (Received < Paid)
- Zero (Received = Paid)
Components of NFIA
There are three main components of NFIA:

1. Net Compensation to Employees: It refers to difference between income from work received by
resident workers living or employed abroad for less than one year and similar payments made to
non-resident workers staying or employed within the domestic territory of the country for less than
one year.
2. Net Income from Property and Entrepreneurship: It refers to difference between income from
property and entrepreneurship (in the form of rent, interest and dividend) received by residents of
the country and similar payments made to the non-residents.
3. Net Retained Earnings: It refers to difference between retained earnings of resident companies
located abroad and retained earnings of non-resident companies located within the domestic
territory of the country.

Extra Discussions:
- “Final Goods are those goods which are consumed only by the households. Defend or Refute
- “Gross investment is always greater than net investment”. Defend or Refute
- “Net Factor income from abroad can never be negative”. Defend or Refute

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 NATIONAL INCOME & RELATED AGGREGATES
NATIONAL INCOME AND RELATED AGGREGATES

Refers to the gross market value of all

final goods & services produced within GDP MP
domestic territory of a country during a
period of 1 year NOTE
While Calculating the
National Income/
LESS: NET INDIRECT TAXES Domestic Income we
(INDIRECT TAXES- SUBSIDIES) know only Factor
Income is considered,
Hence we need to
remove the taxes &
Refers to the gross money value of all subsidies.
final goods & services produced within GDP FC
domestic territory of a country during a
period of 1 year

LESS: DEPRECIATION NOTE

(REPLACEMENT COST OF FIXED CAP) Net of the values need
to be considered

Refers to the net money value

of all final goods & services
NDP FC (DOMESTIC INCOME)
produced within domestic
territory of a country during a

NOTE
ADD: NFIA Nat Income consist of
(F.I.F.A – F.I.T.A) Income earned by
residents from
Domestic Territory and
Refers to the net money value from Rest of the world
of all final goods & services
produced by the normal NNP FC (NATIONAL INCOME)
residents of a country during
a period of 1 year

IMPORTANT POINTS:

➢ Whenever we need to do Conversion then just break down each letter individually and then solve,
there won’t be mistakes while doing the same.
➢ Calculate NIT and NFIA separately in order to avoid silly mistakes

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 DIFFERENCES ASKED:
BASIS DOMESTIC INCOME(NDPFC) NATIONAL INCOME(NNPFC)

NATURE OF It includes that value of final goods It is national concept as it includes the
CONCEPT and services produced value of final goods and services
within the country. produced in the entire world.
CATEGORY It considers all producers within It considers all producers who are normal
OF the domestic territory of the residents of the country.
PRODUCERS country.
NFIA It does not include NFIA. It includes NFIA.

BASIS GDPMP NNPFC

NATURE OF It is territorial concept as it includes It is national concept as it includes the

CONCEPT the value of final goods and services value of final goods and services
produced with produced in the entire
domestic territory of a country. world.
NIT It is market price i.e. it includes It is at factor cost i.e. it does not
net indirect tax. includes NIT
DEPRECIATION Depreciation is inclusive. Depreciation is not included.
NFIA It does not include NFIA because It includes NFIA because it is a
it is a domestic concept national concept

Examples to Solve:

1. Calculate National Income (5050)

Particulars Amount (crs)

GDP at MP 5500
Consumption of Fixed Capital 300
GST 120
FITA 250
Subsidies 70
FIFA 150

2. Calculate Factor Income to Abroad (280)

Particulars Amount (crs)

GNP at FC 4280
Subsidies 80
Factor Income from Abroad 400
Depreciation 480
Indirect Taxes 100
NDP at MP 3700

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 MEASUREMENT
MEASUREMENTOF NATIONAL
OF NATIONAL INCOME INCOME

3 METHODS

Value Added Method Income Method Expenditure Method

Note: -
1. National Income calculated from any of the above methods would be EQUAL.

VALUE ADDED METHOD

Flour → Bread → Sandwich → Movie Hall

₹ 500 ₹ 700 ₹1000 ₹2000
V.A= ₹ 500 (+) ₹700 (-) ₹500 ₹1000 (-) ₹700 ₹2000 (-) ₹1000
=₹200 =₹300 =₹1000

GDPMP= ₹ 2000 (500+200+300+1000)

CONCEPT

• This method is used to measure National Income (NNPFC) in the different phases of
production in the circular flow.
• It shows → contribution made in each production process.
• Value Added Method also known as: - Product Method/ Net Output Method/ Inventory
Method etc.
• Value Added refers to the addition of value to the Raw Material by firm.

Value added = Value of Output (-) Intermediate Consumption

Sales + change in stock
Domestic Consumption + Imports
Domestic sales Closing Stock

(+) (-) Purchases + Expenses*

Exports Opening stock *Those which form part of the production process
Notes: -

1. Expenses included in the production process to be included in calculating Domestic

consumption. I.e. Machine purchased → won’t be a part of domestic consumption.

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 2. If ‘Question’ mentions → ‘Sales’ then includes both domestic sales & exports; phir alag se
add nhi karna.
3. Goods used for self-consumption are included are a part of the “Value of Output”.
4. Services used for self- consumption aren’t included in the calculation of “Value of Output”.
5. Same for → Method of calculating national income: -

GVAMP of Primary Sector *GVAMP= Gross Value Added at MP

+ GVAMP of Secondary sector

+ GVAMP of Tertiary Sector/ Service Sector.

GDPMP

(-) Depreciation
(-) NIT
NDPFC → Domestic Income

+ NFIA [FIFA (-) FITA]

NNPFC → National Income

PRECAUTIONS OF VALUE-ADDED METHOD

1. Production of services for self-consumption (domestic services) are not included. Domestic
services are not included in the national income since it is difficult to measure their market
value. These services are produced and consumed at home and never enter the market
place and are termed as non-market transactions.
2. Production of goods for self-consumption will be included as they contribute to the current
output. Value is to be estimated or imputed as they are not sold in the market.
3. Intermediate goods are not to be included in the national income.
4. Sale & purchase of second hands goods is not included in National Income as they do not
add to flow of goods and services. However, any commission or brokerage on sale or
purchase of such goods will be included in the national income as it is a productive service.
5. Imputed value of owner – occupied houses should be included.
6. Change in stock will be included (C/S – O/S)

Problem of Double Counting**

In measuring the national income, the value of my final goods and services is to be included.
However, the problem of double counting arises when value of intermediate goods is also
included along with the value of final goods.
Double counting refers to counting of an output more than once while passing through various
stages of production.

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 How to avoid Double Counting? (IMP)
1. Final Output Method: According to this method, value of only final goods should be added
to determine the National Income.
2. Value Added Method: According to this method, sum of the value added by each producing
unit should be taken in National Income.

INCOME METHOD

All the incomes that accrue to the factors of production by way of wages, profits, rents, interest etc.
are all summed up to obtain National income
Income method is also known as ‘Distributive Share Method’ or ‘Factor Payment Method’.
Components of Factor income

1. Compensation of employees (COE): - Refers to the amount paid to employees by employer

for rendering productive services.
It includes 3 elements: -
• Wages and Salaries in Cash: -wages, salaries, bonus, dearness allowance, DA,
commission etc.
• Wages and Salaries in Kind: - non monetary benefits →rent free home, free medical
facilities etc.
• Employers Contribution to Social Security Schemes: - it includes contribution made
by employer for the social security of employs. Example: - Contribution to provident
fund, gratuity, labour welfare, and pension funds etc.
Note:

a. Any reimbursement of business expenses incurred by employees will be excluded from COE.
b. Any facility which is necessary for work →NOT INCLUDED.
c. Contribution by Third party (say insurance company) →to an employee is not the part of COE.

2. Rent & Royalty

• Rental income includes both Actual Rent & Imputed Rent (rent in self occupied
properties).
• Royalty refers to the income received for granting leasing rights of sub -soil assets.

3. Interest: Refers to the amount received for lending funds to a production unit
• Includes Actual Interest & Imputed interest.
• ‘Interest Income’ includes interest on loans taken for productive service only.
Does not include: -
• Interest paid by Govt. on public debt & interest paid by consumers such as interest
is paid on loans taken for consumption purposes (personal purposes).
• Interest paid by one firm to another firm.

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 4. Profits: It is the reward to the entrepreneur for his contribution to the production of
goods and services.
a. Corporate Tax
• Tax paid by enterprises to govt.
• Also known as profit tax / business tax.
b. Dividend
• Part of profit paid to shareholder in ratio of shareholdings.
• Also known Distributed profits.
c. Retained Earnings
• That part of profit kept as reserve to meet contingencies or for business operations.
• Also known undistributed profits/ reserve & surplus.

5. Mixed Income
• Income Generated by own – accounts workers (farmers, barbers) and
unincorporated enterprises (like retail traders, small shopkeepers) etc.
• It arises from productive services of self-Employed persons, whose income includes
wages, rent, interests and profits and these elements cannot be separated from each
other.
NOTE: - Operating surplus→ Rent (+) Royalty (+) Interest (+) Profits.
Calculation of National Income

C.O.E (+) rent & royalty (+) interest (+) profits (+) mixed
income-------------------→NDPFC →Domestic Income
(+) NFIA → Factor Income Earned from abroad (-) Factor Income paid from abroad
= NNPFC

Precautions of Income Method

• Transfer Incomes- like scholarship, donations, charity, old age pensions, etc are not included
in the national income because such receipts are not connected with any productive activity
and there is no value addition.
• Income from sale of second hand goods will not be included- in national income as their
original sale has already been counted. If they are included again it would lead to double
counting. However any brokerage or commission received by brokers or commission agents
on sale of such goods, will be included as it is an income received for rendering productive
service.
• Income from sale of shares bonds and debentures will not be included- as such
transactions do not contribute to the current flow of goods and services. These financial
assets are mere paper claims and involves a change of title only. . However any brokerage or
commission received by brokers or commission agents on such financial assets is included as
it is a productive service.

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 • Windfall Gains- like income from lotteries, horse race, etc are not included as there is no
productive activity connected with them
• Imputed value of services provided by owners of production units will be included-
Imputed value of owner occupied houses, interest on own capital , production for self-
consumption, etc. will be included as these are productive activities and add to the flow of
goods and services.
• Payments out of past savings like death duties, gift tax, interest tax, etc. will not be included
in the national income because they are paid out of wealth or past savings and do not add
to the current flow of goods and services.
➢ Always avoid capital gains while calculating national income because these do not
add to the current flow of goods and services.

EXPENDITURE METHOD

• Factor income earned→ is spent in the form of expenditure on purchase of goods & services
produced by the firm.
• Also known as Income Disposal Method

Components
A. Private final Consumption Expenditure.
B. Govt. final Consumption Expenditure.
C. Gross Domestic Capital Formation.
D. Net Exports

1. Private Final Consumption Expenditure: Refers to the expenditure incurred by households

and private non - profit institutions serving households on all types of consumer goods, i.e.,
durable (except houses), semi – durable, non – durable goods and services.

Note: -

• It includes expenditure incurred by Normal Residents.

• Purchase/Construction of Houses → part of Capital Formation.

• Cars, AC → part of Final Consumption Expenditure.

2. Government Final Consumption Expenditure: Refers to the expenditure incurred by general

government on various administrative services like defense, law, orders, education.

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 3. Gross Domestic Capital Formation or [Gross Investment] *
Refers to the addition to capital stock of economy: -

Gross Fixed Capital Formation

(Refers to the Expenditure on purchase of Fixed Assets) Inventory Investment
Refer to the physical
change in the stock.

Closing stock (-) Opening

Stock
a. Gross Business Capital Formation
Refer to expenditure incurred on purchase of new plant
Machinery etc.
b. Gross Residential Construction
Includes expenditure on purchase or construction of new houses by households
c. Gross Public Investment
Construction of flyovers, roads, bridges, by Government.
Note: The above mentioned is Gross Investment and not Net Investment. If it is mentioned as Net
then make sure that we need to add depreciation to it.

4. Net Exports: Refers to the difference between Exports and imports of a Country during a
period of one year.
• Exports refer to expenditure by foreigners on purchase of domestic products. The
exported goods have been produced within the country’s domestic territory. So,
included in output.
• Imports is the expenditure by residents on foreign goods. These are deducted to
obtain domestic products as they are not produced within domestic territory.
• Hence, net exports (Exports [-] Imports)
Note: Net Exports is different than that of Net Factor Income from Abroad.

Calculation of National Income

Private Final Consumption Expenditure
(+) Govt. Final Consumption Expenditure.
(+) Gross Domestic Capital Formation
(+) Net Exports
GDPMP
(-) Depreciation
(-) net indirect taxes
(+) NFIA
NNPFC →National income

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PRECAUTIONS OF EXPENDITURE METHOD
• Expenditure on Intermediate goods will not be included in the national income-as it is
already included in the value of final expenditure. If it is included again, it will lead to
double counting of expenditure.
• Transfer Payments are not included as such payments are not connected with any
productive activity and there is no value addition.
• Purchase of second-hand Goods will not be included as such expenditure has already been
included when they were originally purchased.
Such goods do not affect the current flow of goods and services. However, any brokerage
or commission received by brokers or commission agents on such goods is included as it is
a payment made for productive service.
• Purchase of financial assets-will not be included as such transactions do not contribute to
the current flow of goods and services. These financial assets are mere paper claims and
involves a change of title only. However, any brokerage or commission received by brokers
or commission agents on such financial assets is included as it is a productive service.
• Expenditure on own account production (like production for self- consumption, imputed
value of owner-occupied houses, free services from general government and private non-
profit institutions serving households) will be included in the national income since these
are productive services.

Extra Discussions:

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 RECONCILIATION OF 3 METHODS

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 NATIONAL INCOME AT CURRENT PRICE & CONSTANT PRICE

National Income at Current Price

It is the money value of final goods and services produced by normal residents of a country in a
year, measured at the prices of the current year. It is also known as “Nominal National Income”.
National Income at Constant Price
It is the money value of final goods and services produced by normal residents of a country in a
year, measured at the base year price. It is also known as “Real National Income”.
Note: National Income at Constant Price shows the true picture of economic growth of a country as
any increase in real national income is due to increase in output only.
Conversion of National Income at Current Price into Constant Price >> Price Index
PI is an index number which shows the change in price level between two different time periods. It
indicates whether a rise or a fall in the national income from one year to another is real or not.
Price Index = National Income at Current Prices/ National Income at Constant Price X 100%

BASIS National Income at Current Price National Income at Constant Price

Meaning Mentioned Above Mentioned Above

Index of It is not a good tool for measuring the It is a better good tool for measuring
Economic economic growth of a country. the economic growth of a country.
Growth

Comparison Not Suitable Suitable

Calculation Current Price (P1) X Current Qty. (Q1) Base Year Price (P0) X Current Qty.
(Q1)

Alternative Name Nominal National Income Real National Income

NOMINAL GDP AND REAL GDP

Nominal GDP or GDP at Current Price

When GDP of a given year is estimated on the basis of price of the same year.
Real GDP or GDP at Constant Price
When GDP of a given year is estimated on the basis of price of Base Year, it is called real GDP.

GDP Deflator (or Price Index)

Measures the average level of prices of all goods and services that make up GDP.

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GDP Deflator or Price index = Nominal GDP / Real GDP X 100%
WHICH IS BETTER: NOMINAL GDP OR REAL GDP? (IMP)
Real GDP is better as compared to Nominal GDP. Reasons are as follows:
1. Real GDP helps in determining the effect of increased production of goods and services as it
is affected by change in physical output only. On the other hand, Nominal GDP can increase
even without any increase in physical output as it is affected by change in prices also.
2. Real GDP is a better measure to make periodic comparison in the physical output of goods
and services over different years.
3. Real GDP facilitates international comparison of economic performance across the
countries.
Therefore, Real GDP is better than Nominal GDP as it truly reflects the growth of an
Economy.

GDP AND WELFARE

GDP is often considered as an index of welfare of the people. Welfare means sense of material well-
being among the people. It depends on greater per head availability of goods and services. So,
higher GDP is generally taken as greater welfare of people.
However, this generalization may not be correct due to following limitations or reasons.
1. Distribution of GDP- It is possible that with rise in GDP, inequalities in the distribution of income
may also increase, i.e. the gap between rich and poor increases. GDP does not take into account
changes in inequalities in the distribution of income. So, welfare of the people may not rise as much
as the rise in GDP.
2. Change in Prices- If increase in GDP is due to rise in prices and not due to increase in physical
output, then it will not be a reliable index of economic welfare.
3. Non-Monetary Exchange- Many activities in an economy are not evaluated in monetary terms.
For example- non-market transactions like services of housewife, kitchen gardening, etc. are not
included in GDP, due to non-availability of data. However, such activities influence the economic
welfare.
4. Externalities- Externalities refers to benefits or harms of an activity caused by a firm or an
individual, for which they are not paid or penalized. Activities which result in benefits to others are
termed as Positive Externalities and activities which result in harm to others are termed as Negative
Externalities.

• Example and impact of Negative Externality- Environmental Pollution caused by industrial

plants. Such pollutions reduce the welfare through negative effect on health.

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 • Example and impact of Positive Externality- Use of public parks by the people for pleasure
for which no payments are made by the public. It increases welfare through positive effect
on health.
Such external effects do not form part of market transactions. GDP does not take into account
externalities, negative or positive.
5. Rate of Population Growth- GDP does not consider the changes in the population of a country. If
rate of population growth is higher than the rate of growth of GDP, then it will decrease the per
capita availability of goods and service, which will adversely affect the economic welfare.
Thus, GDP may not be taken as a satisfactory measure of economic welfare due to the aforesaid
limitations, yet it does reflect some index of economic welfare.

GREEN GNP

Green GNP measures national income or output adjusted for the depletion of natural resources and
degradation of the environment. It will help to attain a sustainable use of natural environment and
equitable distribution of benefits of developments. A larger number signifies greater sustainability.

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