UNIT 2 NATIONAL INCOME ACCOUNTING *

Structure

2.0 Objectives
2.1 Introduction
2.2 Circular Flow of Income
2.2.1 Types of Circular Flows
2.2.2 Circular Flow of Income in the Two-Sector Model
2.2.3 Circular Flow of Income with Financial Market
2.2.4 Injections and Leakages
2.2.5 Circular Flow of Income in the Three-Sector Model
2.2.6 Circular Flow of Income in the Four-Sector Model
2.3 National Income and Related Concepts
2.4 Measurement of Related Aggregates
2.4.1 Private Income
2.4.2 Personal Income
2.4.3 Disposable Income
2.5 Let Us Sum Up
2.6 Answers/ Hints of Check Your Progress Exercises

2.0 OBJECTIVES
After going through this unit you will be able to
 assess the relationship between different sectors of an economy;
 explain how national income of an economy is measured; and
 identify the various components of macroeconomic aggregates.

2.1 INTRODUCTION
National income accounting (NIA) is a book-keeping system that a country uses
to measure the level of its economic activity in a particular time period. It records
data on expenditure and income of various stake holders of economy, viz.,
households, firms, government, and external sector of an economy. Although it
cannot measure the economic activity accurately, it provides useful insight on the
functioning of an economy, and on mediums/ channels of the generation of
income and spending. By combining all the information from NIA, we can obtain
the per capita income, and growth over a period of time of an economy. The
performance of an economy is represented through indicators such as gross

*
Dr. Sarabjit Kaur, Zakir Hussain College (evening), University of Delhi.
domestic product (GDP), gross national product (GNP), and gross national National Income
Accounting
income (GNI) which we will discuss in this unit. We will also discuss the other
associated aggregates of an economy.

2.2 CIRCULAR FLOW OF INCOME

Circular flow of income refers to continuous circular movement of goods and
services between major sectors; e.g., Households, Firms (or Business) Sector,
Government Sector, and External Sector (also called ‘Rest of the World’). It is
circular in nature because it moves in a circle coming back to the starting point.
Whenever national output is produced, it generates equivalent amount of claims
of that output in the form of national income. Circular flow of income refers to
flow of money income, or flow of goods and services, across various sectors of
an economy.

2.2.1 Types of Circular Flows

There are two types of circular flows: (i) Real Flow or Product Flow, and (ii)
Income flow or Money flow.

1. Real Flow or Product Flow

Real flows refer to flows of goods and services. These are called real
flows because they consist of actual goods and service. It is also called as
output flow.

2. Income Flow or Money Flow

Money flow refers to flows of money in the form factor payments and
consumption expenditure. The monetary flow occurs because it is through
money that various transactions are conducted, bringing flows of money
from one sector to another. The flow of factor services generates ‘money
flow’ in the form of factor payments, which take the form of ‘income
flow’. The expenditure on goods and service takes the form of
‘expenditure flow’. Both income and expenditure flows are displayed in a
circular manner in opposite directions. In this framework, the economy is
divided in to four sectors, viz., i) household sector, ii) business sector, iii)
government sector, and iv) external sector.

2.2.2 Circular Flow of Income in the Two-Sector Economy

To begin with, let us assume that the economy consists of only two-
sectors, viz., i) households, and ii) firms. In this simplified economy,
there is neither government intervention, nor external trade.

The households spend their entire income, i.e., no saving done by the
household sector. Fig. 2.1 shows the circular flows of expenditure and
income in a two-sector model.
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Issues in
Labour, Land, Capital & Enterprise
Macroeconomics and
National Income
Accounting
Wages, Rent, Interest, Profits

Factor Payments

Business
House
Firms
holds

Consumption Expenditure

Flow of Goods and Services

Fig. 2.1: Circular Flow of Income in a Two-Sector Economy

The upper half of the figure shows the factor market and the lower half presents
the commodity/ product market. The outer two arrows (clock wise) indicate real
flows and the inner two arrows (anti-clock wise) reflect monetary flows. We can
visualize each sector as a buyer and as a seller. The business firms hire factor
services from households, who are owners of factors of production (viz., land,
labour, capital and enterprise) for producing goods and services. The business
firms pay the factors of production remuneration (or compensation) in the form
of money for rendering the productive services. The compensation to a factor of
production or their income, viz., rent, wage, interest and profit for land, labour,
capital and enterprise respectively are generated in the production process. Thus
money income flows from firm sector to the households. With this money, the
households purchase goods and services from the firms or business sector to
satisfy their wants. Thus the same money flows back from households to the firm
sector (remember the assumption that there is no saving by the households – they
spend all their income). Thus the entire income of the economy comes back to
the firms in the form of ‘sales revenue’. Thus we can say that, ‘one sector’s
expenditure is the other sector’s income’.

2.2.3 Circular Flow of Income with Financial Market

In the two-sector model, we assume that all income received by the households
are spent on goods and services. But, in real life, households save part of their
income and receive interest on it. The firms borrow from households for
investment purposes. Financial institutions are intermediaries between savers and
investors (here, households and firms). Financial market collects household
saving and passes it on to the business sector as investment (see Fig. 2.2).
Savings constitute leakages from the circular flow of money and investment
becomes injection in circular flow.
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 Factor Payments
National Income
Accounting

Wages, Rent, Interest, Profits

Saving Investment
Households Financial Business
Market Firms

Expenditure on Goods & Services

Fig. 2.2: Circular Flow of Income in a Two-Sector

Economy with Capital Market

2.2.4 Leakages and Injections

Leakages are the amount withdrawn from the flow of income. It could be in the
form of saving by households, tax payments, or spending on imports. On the
other hand, injections are the amount added to the flow of income. Injections to
the circular flow could be in the form of investment, government spending,
subsidy, or export. Leakages are also called ‘withdrawals’ while injections are
called ‘additions’.

2.2.5 Circular Flow of Income in the Three-Sector Economy

When the government sector (i.e., the third sector of the economy) is added to the
two-sector model, we obtain the three-sector model. In this model, fiscal
operations (taxes, government expenditure and ‘transfer payments’) are added.
These variables have different effects on the income and expenditure flows.

Taxes are leakages from the circular flow as they reduce ‘personal disposable
income’ and hence consumption expenditure and saving. Government spends on
capital goods, infrastructure (e.g., highways, power, etc.), railways, defence,
education, public health, etc. for economic development. Therefore, government
expenditure is an injection in the circular flow as it creates demand in the form of
purchases of factor services from the households, and goods from the business
sector. Further, transfer payments (e.g., pension, unemployment allowance,
subsidy, etc.) are injections in the circular flow (as it creates demand in
household sector). The circular flows of income and expenditure have been
shown in Fig. 2.3.
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Issues in Government
Macroeconomics and Govt. Purchase of Goods
National Income Wages, Salaries
Accounting
Wages, Rent, Interest, Profits

Net Tax
Payment
Factor Payments

Saving Investment
Households Financial Business
Market Firms

Consumption Expenditure on
Goods and Services

Fig. 2.3: Circular Flow of Income and Expenditure in Three-Sector Model

In Fig. 2.3 we find that only money flows among households, firms and
government. Government purchases goods and services from firms and
households, which is as shown in the upper part of Fig. 2.3. Government
expenditure is mainly financed by taxes or borrowings. The second money flow
shows all tax payments made by households and business firms. Households pay
direct taxes to the government, while firm’s earnings are taxed in the form of
corporation tax. Few indirect taxes are levied by government on firms, but
ultimately borne by the households. These money flows include all the tax
payments made by households and firms less transfer payments. Government
also saves and borrows from financial sector like households and business sector
(in order to avoid confusion, we have not shown in Fig. 2.3, the money flow from
financial market to the Government).

If there is surplus in the budget which is a rare phenomenon, then there will be
net leakages from the circular flow of income to the extent of the surplus and
money will flow from the government to the capital market. If surplus is not
spending by the government then the circular flow will contract/decline. Deficit
in budget is the normal phenomenon, which is generally covered by loans and
hence, there will be flow of money from the capital market to the government.
Thus, deficit budget implies injection into the economy resulting in expansion of
circular flow. If government maintains balanced budget; i.e., the amount of
money taken out of the circular flow as taxes will be exactly replaced through
government expenditure.
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2.2.6 Circular Flow of Income in the Four-Sector Model National Income
Accounting
If we do not include the external sector or Rest of World in the circular flow of
income, the model will remain incomplete. The domestic economy is connected
with the Rest of World through international trade (imports and exports) and
financial flows. In Fig. 2.4 we show how money flows in an open economy when
foreign trade exists.

Government

Wages, Salaries
Net Tax Net Tax Govt. Purchases of Goods
Payments Wages, Rent, Interest, Profits Payments

Borrowing for
Households Saving Financial Investment Business Firms
Market

Consumption
Expenditure

Receipts from
Foreign Remittances External Exports(x)

Export of Manpower
Sector
Payments for imports

Fig. 2.4: Circular Flow of Income in an Open Economy

The lower part of the figure shows the circular flow of money in respect of
foreign trade. Export of goods and services bring money into the country in the
form of receipts from export (injections). On the other hand, imports cause
outflow (leakages) of money from the flow.

There exists a balance of trade, if exports and imports are equal. Normally,
exports are not equal to imports. Trade surplus occurs, if value of exports exceeds
the value of imports. On the contrary, if value of exports is less than value of
imports then trade deficit arises. In an open economy, countries also interact with
each other through borrowing and lending funds (financial market). These days,
financial markets around the world have become well integrated.

When exports (X) exceed imports (M), there is a trade surplus in the economy,
and hence, net capital inflow will take place. Net capital inflow means foreign
nationals will borrow from domestic savers to finance their purchases of
domestic exports. Therefore, domestic savers will lend to foreign nationals and
acquire external financial assets. Hence, the circular flow of income goes up
(injections) by the amount of surplus.
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Issues in On the other hand, if there is export deficit or import surplus (i.e., when imports
Macroeconomics and are greater than exports), the country has unfavourable ‘balance of trade’ (trade
National Income
Accounting deficit). Hence, households and business firms will borrow from the Rest of the
World. Hence, foreign nationals will acquire domestic financial assets. In such
cases, the circular flow of income goes down (leakages) by the amount of deficit.

Check Your Progress 1

1) What do you mean by circular flow of income?

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2) Differentiate between Money Flow and Real Flow.

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3) Explain how circular flow of income takes place in the two-sector model.
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4) Explain the difference between leakages and injections.

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5) What are the various effects of inclusion of the government sector in circular
flow of income?

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6) Discuss the effect of adverse and favourable balance of trade on the circular National Income
flow? Accounting

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2.3 NATIONAL INCOME AND RELATED

AGGREGATES

As the name suggests, national income can be defined as the income of a nation
during a period of time. It denotes a country’s purchasing power. It is defined as
the total money value of all final goods and services produced by the normal
residents of the economy in a year. It includes both producer and consumer goods
whether for self-consumption or for exchange. It does not include intermediate
goods and non-economic goods. There are different concepts of macroeconomic
aggregates. Each concept is having specific meaning, method of measurement
and use. These are:

1. Gross Domestic Product at Market Price (GDPMP)

2. Gross National Product at Market Price (GNPMP)
3. Net National Product at Market Price (NNPMP)
4. Net Domestic Product at Market Price (NDPMP)
5. Gross Domestic Product at Factor Cost (GDPFC)
6. Gross National Product at Factor Cost (GNPFC)
7. Net National Product at Factor Cost(NNPFC)
8. Gross Domestic Product at Basic Price

GDP is the sum of the value of all goods and services produced within the
boundaries of a country. For example, India’s GDP includes goods and services
produced by the resident Indians and foreign nationals inside India, but it does
not include goods and services produced by Indians residing abroad. We further
elaborate on the concepts mentioned above.

1. Gross Domestic Product at Market Prices (GDPMP)

GDP is the sum of the value of all goods and services produced within the
boundaries of a country, plus taxes but minus subsidies on imports. GDP is a
flow concept, i.e., flow of goods and services produced during a year.

25
Issues in It does not include previous year production. While calculating GDP, income
Macroeconomics and earned through illegal activities is excluded. Further, transfer payments,
National Income
Accounting capital gains and financial transactions are also excluded from GDP.

GDPMP can be expressed as

GDPMP = Money value of final goods and services produced by national
residents + Income earned locally by foreign nationals – Income received
by nationals residing abroad.

2. Gross National Product at Market Price (GNPMP)

GNPMP is defined as the value of all final goods and services produced in an
economy by its own domestic factors of production, which may be employed
within the economy and abroad in a financial year. The difference between
GNPMP and GDPMP is the ‘Net Factor Income from abroad’. Net Factor
Income from abroad (NFIA) is the difference between the aggregate amount
that a country’s citizens earn aboard and the aggregate amount that foreign
nationals earn in home economy. Thus,

GNPMP = Money value of Final goods and services + Income earned by

National residents in Foreign Countries – Income earned locally but accruing
to foreign nationals.
Or,

GNPMP = GDPMP + NFIA

If the NFIA is positive, i.e., income earned by national residents are more
than foreign nationals earning in that country, then GNP > GDP. On the other
hand, if the NFIA is negative, i.e., income earned by national residents are
less than foreign nationals earning in that country, then GNP < GDP.

3. Net National Product at Market Price (NNPMP)

NNPMP is the total money value of all the final goods and services excluding
depreciation, which is the consumption of fixed capital Thus,

NNPMP = GNPMP – Depreciation

Or,

NNPMP = GDPMP – Depreciation +NFIA

The difference between NNP and GNP is Depreciation, i.e.,
Depreciation = NNPMP – GNPMP

4. Net Domestic Product at Market Price (NDPMP)

NDPMP is defined as the market value of all final goods and services
produced in the domestic territory of a country by its normal residents and
non-residents during financial year less deprecation.
26
 Thus, National Income
Accounting
NDPMP = GDPMP – Depreciation
NDPMP = NNPMP – NFIA

5. Net Domestic Product at Factor Cost (NDPFC)

NDPFC is defined as the sum of all domestic income earned. In other words, it
is total factor incomes earned by all the factor of production. It can also be
calculated by subtracting Net Indirect Taxes (NIT) in NDPMP. The NIT is
equal to indirect taxes minus Subsidies. The NDPFC can be calculated as:

NDPFC = Compensation of Employees + Operating Surplus + Mixed Income

Or,

NDPFC = NDPMP – Net Indirect Taxes

Or
NDPFC = NDPMP – Indirect Taxes + Subsidies

6. Gross Domestic Product at Factor Cost (GDPFC)

It is the sum of net value added by all the producers in the domestic territory
of a country during financial year. It can also be calculated by subtracting Net
Indirect Taxes (NIT) in GDPMP. Symbolically,

GDPFC = GDPMP – NIT

Or,

GDPFC = GDPMP – Indirect Taxes + Subsidies

Or,
GDPFC = NDPFC + Depreciation
= Compensation to Employees + Operating Surplus + Mixed Income

7. Gross National Product at Factor Cost (GNP FC)

It is defined as value of all final goods and services measured at factor cost
produced in an economy by normal residents of a country in a financial year.

GNPFC = GDPFC + NFIA

GNPFC = GDPMP – Indirect Taxes + Subsidies

8. Gross Domestic Product at Basic Prices

GDP is the sum of the value of all goods and services produced within the
boundaries of a country, minus taxes and subsidies on imports.

27
Issues in Notes:
Macroeconomics and
National Income I) Difference between Gross and Net is ‘Depreciation’
Accounting Net = Gross – Depreciation
Gross = Net + Depreciation
II) Difference between National and Domestic is Net Factor Payment from
Abroad (NFP)
NFP = factor Payment from Abroad by Normal Residents – Factor
Payment to Non Residents within Domestic Territory of a country.
National = Domestic + NFP
III) Difference between Market Price and Factor Cost is Net Indirect Taxes
Net Indirect taxes = Indirect Taxes – Subsidies
Market Price = factor Cost + Net Indirect Taxes
Factor Cost = Market Price – Net Indirect Taxes
IV) National Income = NNPFC
V) Net Domestic Income = NDPFC

Example 2.1: Calculate GNP at factor cost and GNP at market price with the
help of the following data.
(Rs. Crore)
1) Compensation of employees 26,142
2) Operating Surplus 12,031
3) Mixed income of self-employed 28,620
4) Consumption of fixed capital 4,486
5) Indirect Taxes 9,703
6) Subsidies 1,350
Solution:
GNPFC = Compensation of employees + Operating Surplus + Mixed Income +
Consumption of Fixed Capital
= 26142 crore + 12031 crore + 28620 crore + 4486 crore
= Rs. 71,279 crore
GNPMP = GNPFC + Indirect Taxes – Subsidies
= 71279 + 9703 – 1350
= Rs. 79632 crore.

Example 2.2: Calculate (a) Net Indirect Taxes, and (b) Net Domestic Product at
Factor Cost from the following data.
Items (Rs. crore)
(i) Net national product at market price 1,400
(ii) Net factor income from abroad (–) 20
(iii) Gross national product at factor cost 1,300
(iv) Consumption of fixed capital 100
(v) National debt interest 18
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Solution: National Income
Accounting
(a) Net Indirect Taxes = Net national product at market price – Net
national product at factor cost (Gross national product at factor cost –
Consumption of fixed capital)

NIT = 1,400 – (1,300 – 100)

= 1,400 –1,300 +100
=Rs. 200 crore

(b) Net Domestic Product at Factor Cost = Gross national product at

factor cost – Consumption of fixed capital – Net factor income from
abroad
NDPFC =1,300 – 100 – (–) 20
=1,300 – 100 + 20 = Rs.1,220 crore

Example 2.3: Calculate NNPFC, GNPMP, GNPFC, and NDPMP from the following
data.

Value in Rs. Crore

NDPFC 1,33,151
Depreciation 11,242
Net indirect taxes 19,183
Net income from aboard (–) 681

Solution:

NNPFC = NDPFC + Net income from abroad

= 1,33,151 + (–) 681 = 1,32,470

NNPMP = NNPFC + Net indirect taxes

= 1,32,470 + 19,183 = 1,51,653

GNPMP = NNPMP + Depreciation

= 1,51,653 + 11,242 = 1,62,895

= GNPMP – net income from abroad

GDPMP
=1,62,895 – (-681) = 1,63,576

GDPFC = GDPMP – Net indirect taxes

= 1,63,576 – 19,183 = 1,44,393

= GDPFC + Net income from aboard

GNPFC
= 1,44,393 + (–681) = 1,43,712

NDPMP = GDPMP – Depreciation

= 1,63,576 – 11,242 = 1,52,334

29
Issues in
Macroeconomics and
2.4 MEASUREMENT OF RELATED AGGREGATES
National Income
Accounting NDPFC or Domestic factor income can be generated in two-sectors: i) Private
Sector, and ii) Public or Government Sector. The NDPFC accruing to private
sector is that part of NDPFC which is in the form of compensation of employees,
operating surplus and mixed income of self employed. The NDPFC accruing to
private sector is given by:

NDPFC accruing to private sector = NDPFC – Income accrued to government

departmental undertaking – saving of non-departmental undertakings

Income from domestic product accruing to government sector has two

components:
i) Income from property and entrepreneurship of government
ii) Savings of non-departmental enterprises.

2.4.1 Private Income

Private income is the total of the income of the factors from all the sources and
current transfers from the government and the rest of the world accruing to
private sector. It can be the income from all the sources i.e., factor incomes and
transfer income received by the private sector. It also includes net factor income
from abroad and interest on national debt (interest paid by the government on the
loans). Hence, private income includes all types of income (earned and
unearned).

Private Income = NDPFC accruing to private sector + NFIA + Net Transfer

payments from government + Net Current Transfer Payments from Rest of World
+ Interest on National Debt

2.4.2 Personal Income

Personal income is the sum of all kinds of incomes received by the individuals
from all sources in the form of current transfer payments and factor incomes in a
year. It includes factor income and transfer income. It does not include corporate
profit tax and retained earnings.

Personal Income = Private Income – Corporation tax – Undistributed Profits +

Transfer payments.

2.4.3 Personal Disposable Income or Disposable Income

Disposable income is defined as income after taxes i.e., income remaining with
individuals after deduction of all taxes (Direct taxes, fees fines etc) levied against
their income and property.

Disposable income = Personal Income – Direct Taxes – Miscellaneous receipts of

the government administrative department (fees, fines, etc.).
30
Example 2.4: Calculate Personal Income and Private Income from the following National Income
data. Accounting

Items Rs. Crore

Retained earnings of private corporation 10
Miscellaneous receipts of government 50
administration departments
Personal disposable income 180
Personal tax 30
Corporate profit tax 10

Solution:

Personal Income = personal disposable income + personal taxes + Misc.

receipts of govt. dept.
= 180 + 30 + 50 = Rs. 260 crore
Private Income = Personal Income + Retained earnings of private
corporation + corporate profit tax
= 260 + 10 + 10 = Rs. 280 crore.

Example 2.5: Calculate a) Personal Income, and b) Personal Disposable

Income from the data given below.

Items Rs. Crore

1. Private income 2000
2. Net retained earnings of private enterprises 600
3. Direct taxes paid by households 200
4. Corporation tax 350
5. National debt interest 250

Solution:

a) Personal Income = Private Income – Net retained earnings of private

interest enterprises – corporation tax
= 2000 – 600 – 350 = Rs. 1050 crore
b) Private Disposable Income = Personal income + Retained earnings of
private corporation + corporate profit tax
= 1050 – 200 = Rs. 850 crore.

Example 2.6: Calculate Net National Disposable Income from the following
data.
Items Rs. Crore
i) Gross Domestic Product at Market Price 2000
ii) Net Current Transfers to Rest of the World (–)200
iii) Net indirect taxes 150
iv) Net Factor Income to Abroad 60
v) National Debt Interest 70
vi) Consumption of fixed capital 200
vii) Current Transfers from Government 150
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Issues in Solution:
Macroeconomics and
National Income
Net National Disposable Income (NNDI) = GDPMP – Net factor Income Abroad
Accounting – Consumption of fixed capital – Net Current Transfers to Rest of the World

NNDI = 2000 – 60 – 200 – (–200)

= Rs. 1940 crore

Example 2.7: Calculate Gross National Disposable Income from the following
data.

Items (in Rs. crore)

(i) National income 2,000
(ii) Net factor income from abroad (–)50
(iii) Consumption of fixed capital 200
(iv) Net current transfers from rest of the world 150
(v) Net indirect taxes 250
Solution:

Gross National Disposable Income (GNDI) = National income + Consumption of

fixed capital + Net current transfers from rest of the world + Net indirect taxes

GNDI = 2000 crore + 200 crore + 150 crore + 250 crore

= Rs.2600 crore

Gross national disposable income = Rs.2600 crore.

Example 2.8: Find out National Disposable Income from the following data.

Items (in Rs. crore)

(i) Current transfers from government administrated departments 215
(ii) Saving of non-departmental enterprises 7
(iii) Net national product at factor cost 325
(iv) Net factor income from abroad 12
(v) Net current transfers from rest of the world 12
(vi) Indirect taxes 35
(vii) Subsidies 10

Solution:

National Disposable Income = Net national product at factor cost + Net current
transfers from rest of the world + Net indirect taxes (Indirect tax – Subsidies)

NDI = 325 crore +12 crore + (35 crore –10 crore)

=325 crore +12 crore +25 crore
=362 crore

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Check Your Progress 2 National Income
Accounting
1) Explain the term National Income.
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2) Can GDP be greater than GNP?

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3) Explain the difference between personal income and private income.

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4) Explain the difference between personal income and disposable income.

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2.5 LET US SUM UP

In this Unit we provided the framework of national income accounting for an
economy. The economy operates mainly through the household sector, firm
sector, government sector and the rest of world. The national income accounting
records the transactions or the flows of income and expenses between these
sectors. The functioning of an economy can be understood by using these
recorded data, which are also used to measures various aggregates such as GDP,
GNP and GNI.
33
Issues in
Macroeconomics and
2.6 ANSWERS/HINTS TO CHECK YOUR
National Income PROGRESS EXERCISES
Accounting
Check Your Progress 1

1. It refers to the flow of money income or the flow of goods and services
across different sectors of an economy.
2. Refer to sub-section 2.2.1.
3. Refer to sub-section 2.2.2.
4. Refer to sub-section 2.2.4.
5. Positive effect: increases circular flow with expenditure and transfer
payments. Negative effect: decreases circular flow by levying taxes.
6. Unfavorable trade: leakages and favorable: injections.

Check Your Progress 2

1. The sum of output produced in the economy.
2. Yes; if NFIA is negative.
3. Use diagram 2.1 and Refer to sub-sections 2.4.1 and 2.4.2
4. Use diagram 2.1 and Refer to sub-sections 2.4.2 and 2.4.3

34