Chapter 6 – National Income Fast Track / Marathon

Chapter -6 National Income Fast Track/ Marathon

National Income: Basics

a) National Income measure short-run performance of an economy.

b) National income gives us an idea of the working of an economy .
c) National income accounts provide a comprehensive, conceptual and accounting framework.
d) National Accounts help us to understand how the various transactions from the stage of
production of goods and services to the stage of their final disposal are interrelated.
e) It helps to meet the needs of Government, private analysts,policy makers and decision
takers.
f) National Income Accounting was pioneered by the Nobel prize-winning economists Simon
Kuznets and Richard Stone
g) The task to measure National Income is undertaken by Central Statistical Organization
(CSO), a department of The Ministry of Statisticsand Programme Implementation (MoSP&I)
h) At the State level, State Directorates of Economics and Statistics (DESs) have the
responsibility of compiling their State Domestic Product and other aggregates.

Distinguish between Non-economic activities and economic activities

1. Economic Activities- Goods and services that can be purchased / exchanged with money.
2. Non-economic activities are those which produce goods and services but are not exchanged
in a market.

What is the national Income ?

National Income is defined as money value1 of final goods and services2 produced by the normal residents3
of a country, whether operating within the domestic territory4 of the country or outside produced within
in an accounting year5.
a. Expressed in Money Value-
 It becomes necessary to measure their value against some commonlyaccepted denominator.
 Thus, money being the measuring rod.

b. Final Value of Goods and services-

1. Value final goods and services are included to avoid double counting.
2. Intermediate goods are those goods and services which are used by producers as input into
further stage of production

The final products are of two types- Consumer Goods and Services and Producer Goods-

1. Consumer Goods- Where the goods and services are used for final consumption bythe consumer,
it is called as Consumer Goods and services.
E.g. – TV, Food, Home appliances.

CA ADITYA SHARMA PAGE NO – 6. 1

Chapter 6 – National Income Fast Track / Marathon

2. Producers Goods- Where the final product is used in production of othergoods/ service in
future, it is called as Producers goods.
E.g. Computer used for developing programs or software, Plant and Machinery used in
manufacturing of goods

c. Normal resident-
1. Normal resident of a country refers to an individual or an institution who ordinarily resides in the
country and whose center of economic interest also lies in that country.
2. Normal residents include both, individuals and institutions.
3. Here the word ‘Resident’ is used and not the word ‘Citizen’. Hence, they may or may not be
citizen of that country

d. Domestic territory:
1. Domestic territory refers to geographical or political boundary of country.
2. It however does not include- international institutional (United nations, WHO, WTO) and foreign
embassies located within geographical territory but includes embassies of this country located
outside itsgeographical territory
3. Indian Ship and Indian aircrafts performing operations outside country is also included in
domestic territory.

e. Current output:
While calculating National income value of only current production is included, this is because the
value of previous year’s production is included in Previous year’s National Income.

National income does not include the following transactions:

1. Pure purchase transaction such as sale and purchase of used goods/ second- hand goods, this is
because nothing new is produced in the current year.
However, where the goods are refurbished the added value must be taken in calculation of National
Income.
2. Sale, purchase of securities is also excluded because it is just a change of ownership.
3. Transfer payments are included as there is no economic activity involved. E.g Pocket money by
Parents, Gift to Son in law.

Transfer Payment-

1) Transfer payments are unilateral payments for which no productiveservices are rendered in
return in the current year.
2) The recipient of this transfer payment does not make any contribution to current
production in return for these payments
3) E.g Pension is given to a person in C.Y for rendering services in past,Unemployment allowance.

There are two types of transfer payments Viz. Current transfer and Capital transfer
4) Current transfer refers to the transfer made out of current income of payer and is added to
current income of payee.
5) Capital transfer refers to transfer made out of the wealth of the payer and added to wealth of
the receiver. (not in our syllabus).

CA ADITYA SHARMA PAGE NO – 6. 2

Chapter 6 – National Income Fast Track / Marathon

Flow concept vs stock concept

Flow concept: - National income is a flow concept because it is measured over a period of time.

USEFULNESS OF NATIONAL INCOME ESTIMATES

➢ It is helpful in many ways such as

a) Helps business Businesses to forecast the future demand for their products.
b) shows the composition and structure of different sectors and the broad sectoral shifts in an
economy over time.
a) Shows income distribution and the possible inequity in the distribution among different income
categories .
b) Helps government to make various sector-specific development policies, make macroeconomic
modeling, comparisons of structural statistics and analysis to increase growth rates.
c) Policy Formulation -Combined with financial and monetary data, national income data provides
a guide to makepolicies for growth and inflation.
c) International comparisons in respect of incomes and living standards assist

Limitation of National Income

1. Income Distribution is not clearly reflected: implies that the gap between rich and poor is
widening
2. If the increase in GDP is on account of long working hours, Employment of child labour, and polluted
working environment, exclusion of leisure such increase in GDP is not the real sign of welfare.
3. ‘How much is produced’ determines GDP. It does not reflect ‘what is produced’.
4. If more of capital goods are produced the GDP will rise but the welfare may not increase in same
manner.
5. Avoids importance of Non-Market Transaction- Example, Such as providing music class to society
children for fun and other similar activity.

Explain the conceptual difficulties or challenges in measurement of national Income

The conceptual difficulties or challenges in measurement of national Income are:

1. Lack of an agreed definition of National Income. (like GDP, GNP, NDP, NNP etc)
2. Non-availability of accurate distinction between final and intermediate goods.
3. Issue of transfer payments.
4. Service of durable goods.
5. Valuation of New goods at constant price
6. Valuation of Government services –
7. Data available are either inadequacy or unreliable for calculation of national Income
8. Presence of non-monetize sector
9. Production for self-consumption

6: GDP AND WELFARE

Can the GDP of a country be taken as an index of the welfare of people in that country?
Answer:

CA ADITYA SHARMA PAGE NO – 6. 3

Chapter 6 – National Income Fast Track / Marathon

GDP is the sign of welfare increase in GDP Increases welfare yet.

- Countries may have Same national income and per capital income but their welfare may vary
significantly .
- Welfare may increase many times but not GDP.
- GDP may increase many times but not Welfare –

THE SYSTEM OF REGIONAL ACCOUNTS IN INDIA

1. All the states and union territories of India compute state income estimates and district level
estimates.
2. Regional accounts provide an integrated database on the many transactions taking place at state
level.
3. State Income or Net State Domestic Product (NSDP)- volume of all goods and services produced
in the state.
4. The state level estimates are prepared by respective State Directorates of Economics and
Statistics (DESs) with assistance of The Central Statistical Organization assists the States.
5. Per Capita State Income = NSDP (State Income) / midyear projected population of the state
6. Certain activities such as are railways, communications, banking and insurance and central
government administration, gives services to many states and their economic contribution cannot
be assigned to any one state directly are known as the ‘Supra-regional sectors’ of the economy.
The estimated value in these cases calculated and distributed to the states on the basis of relevant
indicators

CIRCULAR FLOW OF INCOME

 Circular flow of income refers to the continuous circulation of production, income generation and
expenditure involving different sectors of the economy.
 There are three different interlinked phases in a circular flow of income, namely: production,
distribution and disposition.

1. In Production phase- firms produce goods and services with the help of factor services.
2. In Income or distribution phase, the flow of factor incomes in the form of rent, wages, interest
and profits from firms to the households occurs
3. In Expenditure or disposition phase, the income received by different factors of production is spent
on consumption of goods and services and investment goods. This expenditure leads to further
production of goods and services and sustains the circular flow.

CA ADITYA SHARMA PAGE NO – 6. 4

Chapter 6 – National Income Fast Track / Marathon

Circular flow of income can be viewed from two different angles-

1. What is Real Flow? Real flow consists of flow of factor service and flow of goods and services
among different sector of economy- Yellow Arrows
2. What is Money flow? Money flow consists of flow of money for factor services in form of wages,
rent, dividend (Green arrow) and money expenditure incurred on purchase of goods and services
(Blue arrow/green).

ECONOMIC SECTORS OF AN ECONOMY

1. Household Sector:
2. Business Sectors/ Firm/ Producer:
3. Government Sector:
4. Foreign Sector/ Rest of the World

Models of circular flow of Economy

2 Sector 3 Sector 4 Sector

Household Sector Household Sector Household Sector
Firm Sector Firm Sector Firm Sector
Government Government
Rest of the world
Closed Economy Open economy
.
Two Sector Model without savings- Refer Diagram below
Assumptions:
1. There are only two sectors in an economy. Householdsand the firms.
2. No savings is made by either by Household or by Firm.
3. Households spend entire income on goods and servicesand firm distributes entire proceeds in the
form of factor payments.
In this two-sector model without investment it is assumed that all the income earned by the Household is
spent on buying Consumer Goods from the firm, while all the proceed are distributed as factor payments
to households. Thus, the equilibrium will be achieved.
In other words, there is no leakage in income and the below mentioned equations hold good-
1. Total production of Goods and services by firm= Total consumption of goods and services by households.
2. Factor Income of household= Total factor payments.
3. Income of the firm= Expenditure of the households.
4. Real flow = Money flow

Two Sector Model with Savings and Investment

Assumptions
1. We have assumed that savings is done only byHouseholds and not firms.
2. All the savings made by the households are invested in capital Market.

Savings, Leakage, reduction in flow of income and investment S=I

Savings made by the households and the investments may not be equal in all the time. There are three

CA ADITYA SHARMA PAGE NO – 6. 5

Chapter 6 – National Income Fast Track / Marathon

possible situations mentioned below-

i. If Savings= Investment, equilibrium is achieved
ii. Is Savings > Investment, the flow of income declines
iii. Is Savings < Investment, the flow of income rises

Three Sector Model of circular flow of income

The three-sector model consists of Households, Firmsand Government.

1. The equilibrium condition of circular flow of income in 3 sector economy model is: S+T =
I+G.
2. If (S+T)> (I+G)- Decline in flow of income
3. If (S+T)< (I+G)- Increase in flow of income

Four Sector Model of circular flow of income

It is also called as open economy model as it is engaged in international operations too.
Explanation:
 Export is denoted by X while Import is denoted by M.
Thus, it can be said that X constitutes injection while M creates leakage into circular flow of
income.
1. At equilibrium = S+T+M = I+G+X
2. If S+T+M > I+G+X, there is decline in flow of income.
3. If S+T+M < I+G+X, there is increase in flow of income

Distinction between three and four sector Economy model:

Importance of Circular Flow of Income

1. Easy to view the entire system as circular flow of income.
2. Circular flow of income pinpoints the condition of macroeconomics equilibrium.
3. It gives an idea as to how different sectors of economy interacts
4. It shows how different sectors of economy (Household sector, Business sector, Government and
Rest of the world) are interdependent and are interrelated.
5. It helps in determining size of income. We can estimate national income with the help of output,
income and expenditure phases of circular flow of income

Thus,
National Income refers to -
1. Money Value of all the final goods and services produced by a country during a year.
(Production Phase)
2. Total Flow of Earnings of the Factor Owners, in the form of Wages, Salaries, Rent, Interest
and Profits, which they receive through the production of goods and services. (Income
Generation Phase)

CA ADITYA SHARMA PAGE NO – 6. 6

Chapter 6 – National Income Fast Track / Marathon

Unit 2- National Income Aggregates

Domestic Product and National Product (Domestic income and National Income)

Particulars Domestic Products National Products

Meaning Money value of Final Goods and service Money value of Final Goods and
produced by both, nationals of the service produced by Normal
country as well as foreign national Resident of a country whether
located within domestic territory of operating within domestic
a country during a year territory of a country or outside.
Basis of differentaition  Addressed with the question of  It can be addressed with the
where theincome is generated. question of who generates the
 It is geography or territory income.
oriented  It is Nationality Oriented.
 It excludes foreign national

.
Net factor Income Earned from Abroad
Net factor Income Earned from Abroad or NFIA is the difference between the factor income received
and the factor income accruing to rest of the world

National Product at Market Price and National Product at Factor Cost

1) Factor cost refers to factor payment made by the business to the owners of factor of
production in the form of rent, wages, interest and profit

2) National product at Market price = National Product at factor cost + Indirect tax*-
Subsidies, or

3) National product at Market price = National Product at factor cost + Net Indirect tax**

Factor Cost vs Basic Price vs Market Price

1) Factor cost = Sum total of factor income in form of rent, wages, interest and profit
2) Base Price: = Factor cost + Production tax (License, Stamp duty, municipal tax, property tax)
– Production subsidies
3) Market price = base price + Product tax (Indirect tax/ GST) – product subsidy
4) Market Price: Basic Price + Product tax – Product Subsidy = Market Price.
5) MP = FC + Net Indirect tax (when production tax and production subsidies are not given)

Gross Vs Net
Net domestic Product = Gross domestic Product – Depreciation
Net national Product = Gross national Product – Depreciation

1- Gross Domestic Product at Market Price - GDPMP

2- Gross National Product at Market Price - GNPMP

3- Net Domestic Product at Market Price – NDPMP

CA ADITYA SHARMA PAGE NO – 6. 7

Chapter 6 – National Income Fast Track / Marathon

4- Net National Product at Market Price - NNPMP

5- Gross Domestic product at Factor cost – GDPFC

6- Gross National product at Factor cost – GNPFC

7- Net Domestic product at Factor cost – NDPFC

8- Net National product at Factor cost - NNPFC

Why NNP at factor cost is better measure of National Income than NNP at Market Price?
Answer: NNP at Market price is affected by factor called as Net indirect tax. If there is change in
tax rate and subsidy then NNP at market price figure will change accordingly without actual increasein
Factor cost. Also, different countries have different tax rate and thus for internationalcomparison
of relative income level.

Types of Income:
Disposable Income available for disposable and it includes transfer payments.
income Example, Income may be 10,000 but one may also receive transfer payment which will increase
the money received by him to the extent of transfer payment say 2000. Therefore, Income
is 10000 while Disposable income is 12000
Thus,
Disposable income= Income + Net Transfer payment**
Disposable income may be more or less depending upon whether Net
transferpayment is positive or negative

National National Disposable income is the sum total of National Income at Market
Disposable priceand net of Current transfer received from rest of the world
Income GNDI = GNPMP + Net transfer Payments received from rest of the world
NNDI = NNPMP + Net transfer Payments received from rest of the world
NNDI = GNPMP + Net transfer Payments received from rest of the world- depreciation

Disposable There are three disposable income aggregates, namely-

income of 1. Private Income
Private 2. Personal Income
sectors 3. Personal Disposable income

Less Miscellaneous receipts of Govt. department. Fines, fees etc. 30

Less Personal taxation 60
Personal Income 640
Per a) It serves as an indicator of the standard of living of a country.
Capital b) Per capita income = NNPFC / Population
Income

CA ADITYA SHARMA PAGE NO – 6. 8

Chapter 6 – National Income Fast Track / Marathon

Summary
GNDI = GDPMP + Net transfer payment received from rest of the world
NNDI = NDPMP + Net transfer payment received from rest of the world
Private Income = NNPFC - Income from property and entrepreneurship accruing to govt. commercial
enterprises and admin department- Savings of non- Departmental enterprises of government
+Interest on national debt +Net Current Transfer payment received from Govt. dept
+Net transfer payment received from rest of the world
Personal Income = Private Income – Undistributed profits- Corporate taxes
Personal disposable income = Personal income- Personal taxes- Miscellaneous receipts of Govt.
department.
.
*Interest that Govt. pays on National debt: Sometimes govt. borrows fund from private
institutionand pays the interest on the same. The interest shall be included in factor payment by
it is argued that the monies are utilized for welfare purpose and thus shall be treated as Transfer
payment.
**The private sector receives transfer payment both from Govt. and rest of the world. Reverse is
also true in many cases.

Nominal GDP Real GDP

Also known as GDP at Current price GDP at Constant price
Meaning GDP at Current price is the value of all GDP at Constant price is the value of all final
final goods and services produced within goods and services produced within the
the domestic territory of a country by domestic territory of a country by normal
normal residents, whether nationals or residents, whether nationals or non- nationals,
non- nationals, inclusive of depreciation inclusive of depreciation during a year at
during a year at market price prevailing in market price prevailing in base year
that year
GDP at constant price =
GDP at Current price x 100
Price index of current year
.

GDP Deflator: It is the ratio of Nominal GDP (at Current Prices) to Real GDP (at Constant price)
GDP Deflator: Nominal GDP
.
Real GDP
a) GDP Deflator takes out the Inflation out of Nominal GDP. It deflates the GDP.
b) It converts Nominal GDP to Real GPD
Inflation:
a) Using the GDP deflator, the inflation rate between two consecutive years can be compute
using the following procedure:

b) GDP deflator in year 2 -GDP deflator in year 1

Inflation rate in year 2 = x 100
GDP deflator in year 1

CA ADITYA SHARMA PAGE NO – 6. 9

Chapter 6 – National Income Fast Track / Marathon

Methods of Measuring National Income

There are three ways to measure National Income
1. Product method or Value-added method- Flow of Goods andservices
2. Income Method- Flow of income generated
3. Expenditure Method- Flow of Expenditure on Goods andservices

Net product or Value-Added Method

Meaning National income by value added method is the sum total of net value added at
factor cost across all producing units of the economy less intermediate
purchases from all other industries.
Steps 1 Identifying the producing enterprises and classifying them into different
sectorsaccording to the nature of their activities
(i) Primary sector- production units which produces goods and commodities
by exploiting natural resources. Examples- farming, Mining, Fishing, etc.
(ii) Secondary sector- This sector transforms one for of commodity into other
formsuch as manufacturing
(iii) Tertiary sector or service sector- Provides services which are intangible
in nature.
Step 2 Estimating the gross value added (GVA MP) by each producing enterprise.
Gross value added (GVA MP)
= Gross Value of production – value of Purchase
= Value of output – Intermediate consumption
= (Sales + change in stock) –Intermediate consumption.This will Give us GDPMP
Step 3 Conversion:
• GDPMP- depreciation= NDPMP
• NDPMP- Net indirect tax = NDPFC
• NDPFC+ NFIA= NNPFC
Inclusion and Precaution in Estimation of National Income by Value-added Method-
exclusions 1. Production for self- consumption
2. Own account production of fixed assets.
3. Imputed rent of owner-occupied houses.
4. Service of House wives shall.
5. Sale and purchase of existing commodities or second-hand goods shall
not beincluded. However.
6. Sale and purchase of Share and Bonds
.
.
Income Method/ Factor Payment Method/ Distributed Share Method

Meaning National income is calculated by summation offactor incomes paid out by

all production unitswithin the domestic territory of a country as wages and
salaries, rent, interest, and profit.

Steps 1 Classify the income into appropriate income categories namely,

1. Labour Income or Compensation to employees
2. Capital or Property income or Operating surplus

CA ADITYA SHARMA PAGE NO – 6. 10

Chapter 6 – National Income Fast Track / Marathon

3. Mixed Income of self employedThis will give NDPFC

Step 3 The above exercise will give NDPFC. The adjustment of NFIA will give
National Income
Labour ➢ This is the compensation paid to the labour/ employee for the
Income servicerendered by them.
➢ It is the payment made by the producer to employees or labour, for the
services rendered by them, in cash, kind and social security benefits.

Included Excluded
Salaries and wages in cash including Old age pension shall not be
Bonus, DA, HRA considered while calculating Labour
income as it is a transfer payment
Current year pension provision shall TA shall be excluded if it is for
be considered. business work or on reimbursement
basis.
Travelling allowance shall be Contribution of employee to social
included security fund shall not be added as
if it is for travel form office tohome it is already part of salary.
and home to work
Contribution of employer to social Interest free loan given to employee
security fund shall be added. E.g.
Provident fund
Commission paid to sales staff Old age pension
Payment in kind- Rent free Income tax of employee
accommodation, Free Meal coupon
LIC premium paid by employer Old age pension shall not be
considered while calculating Labour
income as it is a transfer payment

Operating
Surplus

It is the income earned from ownership and control of Capital. Therefore, it

is alsoknown as income from property and entrepreneurship.

CA ADITYA SHARMA PAGE NO – 6. 11

Chapter 6 – National Income Fast Track / Marathon

It includes
▪ Rent- including self-occupied house, in the form of imputed rent
▪ Interest
▪ Royalties for
▪ Profit before tax
Note:
✓ If the question mentions about Profit before tax than Undistributed
profit,dividend and corporate taxes shall be ignore.
✓ If the question does not mention about the profit before tax- add all three
✓ If nothing if prefixed to profit, assume it to be PBT
✓ Interest paid by government debt and interest paid by consumer on
borrowingsare not included because these are treated as transfer payment

Mixed ➢ Mixed income is the income generated by own account workers and income
Income of unincorporated enterprises.
➢ Example of such mixed income are legal service, agriculture, trading,
proprietorship, Plumber, carpenter etc.
➢ Mixed income contains both components of income namely capital income
and labour income of those who provides capital and labour service in
production process.
➢ It is the composite of both labor income and capital income and arises
in case where it is difficult to differentiate between labour element and
capital element I factor of production.
Example of such incomes are own account workers like CA, Lawyer,
Shopkeeper etc.
Inclusion Include Exclude
and exclusion Imputed rent of self-occupied Transfer payment- Refer earlier
house by owner of this house part of the chapter
Value of production for self- Illegal Income like, smuggling, drug
consumption dealing etc.
Imputed value of service provided Interest on loan taken for meeting
byowner of production unit consumption expenditure- eg. Loan
to buy house, loan to buy car, etc.
Interest on loan taken for meeting Interest on national debt- refer
business needs earlier discussion
Brokerage service in facilitating the Income in respect of second-hand
transaction of second-hand goods commodities
Income tax and TDS to show gross Income arising from transfer of
income shares and other securities.
.
Difficulties 1. It is very difficult to estimate Mixed income in vast country with
unincorporated sectors and un-organized sector.
2. Many economists criticize the non-inclusion of interest on national debt in
calculation of national Income.
3. The data collected for calculation of NI is highly unreliable and

CA ADITYA SHARMA PAGE NO – 6. 12

Chapter 6 – National Income Fast Track / Marathon

understated.

Expenditure Method/ Income disposal Method

Meaning In the expenditure approach, national income is the aggregate final

expenditure in an economy during anaccounting year.
This approach gives GDP at market price.
Explanation: Expenditure on final goods and services in the economy is divided into four broad
categories, namely
1. Private final consumption expenditure- Consumption expenditure done by
households.
2. Investment Expenditure- Investment expenditure done by producers and
Government in an economy.
3. Government final consumption expenditure- Consumption expenditure done
bygovernment.
4. Net exports- foreign component of expenditure in the form of net exports.
Private Final The volume of final sales of goods and services to consumer households and
consumption nonprofit institutions serving households acquired for consumption (not for use
expenditure in production) are multiplied by market prices and then summation is done.

Denoted By C It also includes the value of primary products which are produced for own
consumption by the households, payments for domestic services which one
household renders to another.
Government Government means general government and not the government enterprises Since
final the collective services provided by the governments such as defense,education,
consumption healthcare etc. are not sold in the market, the only way they can bevalued in
expenditure money terms is by adding up the money spent by the government in theproduction
of these services. This total expenditure is treated as consumptionexpenditure
Denoted of the government.
By G Government expenditure on pensions, scholarships, unemployment allowance etc.
should be excluded because these are transfer payments.
Investment Gross domestic fixed capital formation includes final expenditure on machinery and
Expenditure equipment and own account production of machinery and equipment, expenditure
on construction, expenditure on changes in inventories, and expenditure on the
Denoted acquisition of valuables such as, jewelry and works of art.
By I It comprises of-
1. Gross fixed investment-
Expenditure on machinery and equipment, expenditure on construction, and
expenditure on the acquisition of valuables such as, jewelry and works of art.
2. Inventory Investment-
This means change in inventory.
3. Expenditure on residential investment-
Expenditure on purchase or construction of new houses. Own account production
of houses, expenditure on major repairs and renovation are to be included in

CA ADITYA SHARMA PAGE NO – 6. 13

Chapter 6 – National Income Fast Track / Marathon

expenditure on residential houses

Net Export Net exports are the difference between exports and imports of a country during
Denoted by the accounting year. It can be positive or negative.
X-M
Formula GDPMP = C+I+G+(X-M)
Therefor National Income
Y = C + I +G + (X-M) +NFIA- Depreciation- NIT

Precautions 1. Goods meant for self-consumption shall be added and proper value shall
beassigned in that case.
2. Own account production of machinery and equipment shall be added to
calculatefinal expenditure on machinery and equipment.
3. Transfer payments shall be excluded.
4. Expenditure on second-hand goods should be excluded.
5. Expenditure on intermediate products should be excluded.
.
Question: Why are net exports added when computing national income by expenditure Method?

Choice of Different method

In many economies, it may not be possible to estimate National Income using any one method
exclusively.
a) Income Method is more suitable in Developed Economies.

b) If Commodity Flow and Expenditure then Expenditure Methodcan be used.

c) An effective procedure is to arrive at National Income using all these three approaches /
methods, which serves the following purposes -
i. to permit cross-checking of different methods, ensuring greater accuracy of data,.
ii. to provide more details and insights - e.g. Sectoral Contribution to Production, Income
Group Distribution, Consumption and Investment Patterns, etc .

In India, a combination of the three methods is used, e.g. Production Method is used for Agricultural
Sector, Income Method is used for Small Scale Sector and Expenditure Method is used for Construction
Sector, to determine Net Value Added in that Sector.

Keynesian Theory of Income determination

Background:
The Great Depression of the 1930's, was the greatest economic crisis the western world had
experienced.
Many economists then recommended government spending as a way of reducing unemployment,
but they had no macroeconomic theory by which to justify their recommendations.
A comprehensive theory to explain Income determination was first put forward by the British
economist John Maynard Keynes in his masterpiece ‘The General Theory of Employment Interest
and Money’ published in 1936.

CA ADITYA SHARMA PAGE NO – 6. 14

Chapter 6 – National Income Fast Track / Marathon

The Keynesian theory of income determination is presented in two sector model, three sector model
and four sector mode.
Equilibrium output occur when the desired amount of output demanded by all the agents in the
economy exactly equals the amount produced in a given time period. In other words, an economy is
said to be in equilibrium when the production plans of the firms and the expenditure plans of the
households match.
Key Words:

Consumption 1. Functional relationship between aggregate consumption expenditure and aggregate

Function disposable income, expressed as C = f (Y). shows the level of consumption (C)
corresponding to each level of disposable income (Y).
2. The consumption function describes the functional relationship between
consumption spending and disposable income.

Saving Income not spent on consumption is saved. Thus, saving function denotes the balance
Function after impact of consumption
Marginal The concept of MPC describes the relationship between change in consumption (∆C) and
Propensity to the change in income (∆Y). The value of the increment to consumer expenditure per unit
consume of increment to income is termed the Marginal Propensity to Consume (MPC).

MPC = Consumption / Income

Marginal (1 – b) is called (Marginal Propensity to Save) MPS.
propensity to MPS = S/ Y
Save (MPS)
Average The average propensity to consume is a ratio of consumption defining income consumption
propensity to relationship. The ratio of total consumption to total income is known as the average
consume propensity to consume (APC)
APC = Total consumption/ Total income

Income Consumption (C) APC (C/Y) MPC (∆C /∆Y) MPS (∆S/∆Y)
(Y)
=(1-MPC)

0 500 500/0 =∞ - -

1000 1250 1250/1000 = 1.25 750/1000 = 0.75 0.25

2000 2000 2000/2000 = 1.00 750/1000 = 0.75 0.25

3000 2750 2750/3000 = 0.92 750/1000 = 0.75 0.25

6000 5000 5000/6000 = 0.83 1500/2000 = 0.75 0.25

10,000 8000 8000/10,000 = 0.80 3000/4000 = 0.75 0.25

Autonomous Autonomous consumption expenditure is the minimum expenditure to sustain life
Expenditure irrespective of size of income, thus it is income inelastic. The expenditure which do not
vary with the level of income. They are determined by factors other than income such as
business expectations and economic policy. They are generally made by -----
in the public sector with a view to provide public utilities & to make maximum social
benefit.

CA ADITYA SHARMA PAGE NO – 6. 15

Chapter 6 – National Income Fast Track / Marathon

Keynesian theory of determination of National Income in two Sector Model.

i. According to Keynes AD=AS (1)

ii. AD = C+ I (2)
iii. Aggregate Supply in terms of Money = Quantity Produced x Price.
iv. Value of Aggregate Supply = National Income. (3)
v. Income (Y) = C+ S (4)
vi. Therefore from (1), (2), (3) & (4)
vii. C+S = C+I
viii. S=I
ix. C = a + by

❖ Why any other point cannot be Equilibrium NI?

❖ Case 1: AS > AD i.e C+S > C+I
Ans: The firm will not be able to sell its stock & firm will reduce the production and cut down on
expenditure, as a result demand for factor of production will decrease, in case of Factor will
reduce and thus spending will fall. This process will continue till equilibrium is reached.

❖ Case 2: AS<AD i.e C+S < C+I

Ans: Here Demand is greater than supply and hence producer will increase the production leading
to higher National income. This will cause upward moment along the line to achieve the equilibrium

Keynesian theory of determination of National Income in three Sector Model.

Y= AS = C + S + T (2)
Ad = C + I + G _ (3)

 Consumption will be- C = a + b (Yd)

Keynesian theory of determination of NI in Four Sector Model.

In 4 Sector Economy
AS = AD
C + S + T = C + I + G + (x – m)
S + T = I + G + (x – m)
OR S + I + m = I + G + x

Investment Multiplier:

1. The multiplier refers to the phenomenon whereby a change in an injection of expenditure wil
leadto a proportionately larger change (or multiple change) in the level of national income.
2. Multiplier explains how many times the aggregate income increases as a result of an increase in
investment.
3. The ratio of ∆Y to ∆I is called the investment multiplier, k.
4. ∆ Y = k ∆I.

CA ADITYA SHARMA PAGE NO – 6. 16

Chapter 6 – National Income Fast Track / Marathon

5. The value of the multiplier is found from the equation k = 1/ (1− MPC). Or K = 1/ MPS

6. The multiplier shows how shocks to one sector are transmitted throughout the economy.

Effect of Changes in Autonomous Investment

1. an increase in autonomous investment by ∆Ishifts the aggregate demand schedule from C+I to
C+I+∆I.
2. Correspondingly, the equilibrium shifts from E to E1and the equilibrium income increases more
than proportionately from Yo to Y 1.

Till how long these processes go?

1. The more powerful these leakages are, the smaller the value of the multiplier. The leakages are
caused due to:
a) Progressive rates of taxation
b) High liquidity preference and idle saving or holding of cash balances
c) Demand met out of the existing stocks or through imports.
d) Additional income spent on purchasing existing wealth or purchase of government
securities and shares from shareholders or bondholders, income used for payment of
debts
e) case of full employment additional investment will only lead to inflation, and scarcity of goods
and services despite having high MPC
In underdeveloped countries value of multiplier is low, due to structural inadequacies, increase in
consumption expenditure is not generally accompanied by increase in production.

Relationship between Investment Multiplier and Marginal Propensity to consumer

Higher the MPC, Higher will be the Value of Multiplier, and Vice versa. Maximum Value of Multiple will be

Infinite when MPC is 1. We conclude that value of Multiplier is reciprocal of MPS (1-MPC)

Deflationary Gap
1. If the aggregate demand is for an amount of output less than the full employment level of output,

then we say there is deficient demand.

2. Deficient demand gives rise to a ‘deflationary gap’ or ‘recessionary gap’.

3. Recessionary gap also known as ‘contractionary gap’ arises in the Keynesian model of the macro

economy when the equilibrium level of aggregate production achieved in the short-run falls short of

what could be produced at full employment.

4. Recessionary gap occurs when the economy is in a business- cycle contraction or recession.

CA ADITYA SHARMA PAGE NO – 6. 17

Chapter 7 Public Finance

Public finance –
Market Failure and Government Intervention
2.1.1 Market Failure

Economists presume that people will make choices in their own self-interest, in their greatest
personal benefit and behave rationally.
Prices provide the accurate signals for right quantity and right price.
The term “market failure” does not mean the market is not working at all, it only means that the
market does not function in the way that it should.
Market failure - misallocation of society's scarce resources - either overproduction or
underproduction.
There are two types of market failure namely;
1) Complete market failure. This is a case of "missing markets" and occurs when the market does
not supply products at all.
2) Partial market failure occurs when the market does actually function, but it produces either
the wrong quantity of a product or at the wrong price..

2.1.2 Four major reasons for Market Failure

Market Power

Point Explanation
Meaning 1) Market power or monopoly power is the ability of a firm to profitably raise the
market price of a good or service over its marginal cost and can charge a price that
gives them positive economic profits.
2) These profits are not achieved due to operating efficiency, but due to market
power and dominance.
3) For Buyers: Market Power is the ability of Buyers to influence the Seller into the
production of certain goods and services, over and above optimum levels of
consumption. (Generally, Market Power is viewed from the Sellers' Perspective)
Techniques 1. Lower output: (artificial scarcity)
2. Higher Price:
3. Missing Markets:
.
Externalities | Spillover effects | Neighborhood effects | Third-party effects | side-effect
(Kare koi aur bhare koi aur)
Point Explanation
Meaning and 1. When actions of either Consumers or Producers result in costs or Benefits
concept that do not reflect as part of the Market Price, such costs or Benefits which
are not recognized by, and accounted for, by the Market Price are called
“Externalities”

CA Aditya Sharma Page No. 7.1