The circular flow of income shows the interconnected flows of goods, services, and money between households and firms in an economy. Households provide factor services like labor to firms and receive income, while firms produce goods and services and sell them to households. This results in a circular flow as money flows from households to firms and goods/services flow from firms to households. GDP can be measured using the income, expenditure, and production approaches, which should all equal the total value of final goods produced in an economy in a given time period when accounting properly.

1. Chap 005
Circular Flow of Income

2. Circular Flow of Income
This is a basic way of understanding how different parts of the
economic system fit together.
• The circular flow of income shows connections between different
sectors of our economic system.
• It revolves around: flows of goods and services and factors of
production between firms and households.
• Businesses produce goods and services and in the process of
doing so, incomes are generated for factors of production (land,
labour, capital and enterprise) – for example wages and salaries
going to people in work.
• To explain it we take a simple model of economy, which consists of
two sides,
– firms
– households.

3. Households and Firms
– Households
– Individuals or people living together as decision-making
units.
– Households mean families or those individuals who are
independent in spending their incomes.
– Firms
– Institutions that organize production of goods and services.
Markets
– A market is any arrangement that brings buyers and sellers
together and enables them to get information and do
business with each other.
– Factor (resource) markets are markets in which factors of
production are bought and sold.
– Goods (Product) markets are markets in which goods and
services are bought and sold.

7. Real Flow & Money Flow
We have explained the working of firms and households separately and have
found that in an economy two types of flows take place. Real flow & Money
Flow
a. Real Flow
Factor Services of labour, land, and capital going from households to firms,
and products of firms as physical goods or services flowing to households.
The anti-clockwise outer circle is a real flow in the sense that it shows the
flow of goods from producing units to consuming units and flow of factor
services.
b. Money Flow
Firms making payments to households for factor services and households
spending money to buy goods from firms.
The inner circle is a monetary flow. Money flows from households to firms
against purchase of goods and then from firms to households as payments for
factor services.
• In each market there is a MONEY FLOW (payment)
• And a REAL FLOW (good, service or factor of production for which a payment is
made)
The important fact about these flows is that they are never isolated. They are inter-
related. When shown together in a diagram we get an interesting picture of national
income in which production and consumption activities go on in a circular flow.

10. Families do not immediately spend all of their income on consumer items.
They save a part of it. These savings are a type of leakage in income stream.
At the same time firms make investments (spend on machinery etc.). This investment
spending is a kind of injection in the income stream.

14. Measurement Of National Income (GDP)
• Measurement of national income is very difficult task. Income is
produced at millions of places and by millions of people working at
fields, factories, shops, offices or construction sites etc. and there are
thousands of ways or activities through which people can receive
income. Therefore, exact measurement is not possible. Only a good
estimate can be made.
• For every rupee of output produced, a rupee of income is created and
this rupee either goes to consumer spending or saving or tax payments.
• This fact leads us to three alternative ways of measurement of national
income.
1.
2.
3.

16. Income Method (or National Income or GDP at factor cost)
— This method is derived from the concept of national income as
“the sum total of the incomes of all the persons of a country
during one year.”
— The total income earned by the factors of production owned by
a country’s citizens.
— Measuring GDP using the income approach means to sum up
the incomes that firms pay households for the factors of
production they hire, for example, labour, land, capital and
entrepreneurs.

17. Example: We assume that the people of a country receive their incomes in
the following forms.
Sources of Income Amount (Rs.in Billions)
Wages & Salaries(earned by workers and employees 200
Rent (of houses and lands) 30
Interest(Received on loans) 20
Profits of corporate sector(i.e. joint stock companies) 50
Proprietor’s Income(earned by small business organizers) 60
Indirect business taxes(taken away by the government) 40
National Income 400
The advantage of measuring national income through this method is that we come to
know the distribution of national income among various group of society such as
landlords, capitalists, workers and businessmen

18. Precautions
• The following precautions are necessary to apply this method
– Transfer payments such as pensions, gifts, zakat and
scholarships are not included. Transfer payments no doubt are
source of personal incomes for some people but they do not
make any addition to national income in true sense. These are
payments received without performing any productive work.
– Incomes from illegal sources like smuggling, theft and bribery
are ignored.

20. Expenditure Method (or National Income or GDP at
Market Prices)
Expenditure approach sums up the total expenditure in a country (there are four
groups that purchase final goods and services, namely, households, firms,
government and overseas consumers).
The expenditure of these four groups can be divided into four categories,
namely:
— Personal Consumption Expenditures (Consumer Goods and Services),
This includes all consumer’s expenditure on good and services.
— Gross Investment Expenditure (Business Goods and Services ),
This is expenditure on fixed assets(buildings, machinery, equipment, vehicles
etc.) and changes in value stock of goods.
— Government expenditure: (Government purchases of final goods and
services.)
This includes expenditure on defense, police, education and other services.
— Exports minus Imports: (Net Exports or imports of Goods and services)
This is because imports do not represent our domestic production, expenditure
on imports is excluded. Instead value of exports is included.

21. Expenditure Method cont’d
If we use symbols, we can write:
Y=C+I+G+(X-M)
– Y= National Income
– C= Consumption
– I= Investment
– G= Government Expenditure
– X= Exports
– M= Imports
• GDP = Gross Private Consumption Expenditures (C) + Gross
Private Investment (I) + Government Purchases (G) + Exports (X)
– Imports (M)

22. Example: it is generally assumed that total expenditure in a
country can be groped under four items.
Item of expenditure Amount(Billion Rupees)
Private consumption expenditure 250
Gross domestic investment 50
Government Purchases 90
Exports minus imports 10
National Income 400

23. Precautions
The precautions to be taken in this method are:
• Care is taken that every expenditure is counted only once.
• Expenditure on second hand goods is to be excluded. Such sales
either do not reflect current production or involve double
counting. Thus purchase of an old house or old car is not
included.

25. Production or Value added Approach
This method is based on the concept of national income as “total market value
of final (a final product is a good or service that is purchased by the ultimate
user, and not intended for resale or further processing) goods and services
produced in a country during one year.
Thus method of computing GDP/GNP that measures the economy based on the
contribution of industries and sectors to the value of the final goods.
• Primary Sector:
Agriculture, Fishery, and Forestry (AFF)comprises produce such as corn,
coconut, copra, sugarcane, livestock, poultry, agricultural services, fishery,
and forestry.
• Secondary Sector:
Industry (I) comprises main sectors mining and quarrying, manufacturing,
construction, and electric, gas, and water.
• Tertiary Sector:
Services (S) comprises the following sectors: transportation,
communications, and storage, trade, finance, ownership dwellings and real
estate, private services, and government services

29. Example:
This method is explained by the following example. A country’s
economy has been divided into seven sectors.
Production Sector Net Value Added(Billion Rs)
Agriculture (includes livestock like poultry,
dairy products, fruits and forestry)
120
Manufacturing 80
Trade 50
Transport & communication 40
Construction 30
Electricity , gas 20
Services(Defense, public administration,
education, health)
60
National Income 400
Product method is useful to know the relative importance of various sectors of the
economy.
The above table shows that agriculture makes the greatest contribution to national
income of this country.

30. Precautions
When calculating national income m everything must be counted once. Most of
the products go through a number of stages in the process of production. They
maybe sold a number of times before reaching the hands of the final user. Unless
we are careful we may make mistake and count some things more than once. For
example bread is counted but flour that was used for bread is not counted.
• The following precautions are observed in this method.
i. Double Counting is avoided because it causes over estimation of national
income.
• Example: production of a shirt
Stage of production Sale price of product in the market Value-added at each stage*
Cotton Rs. 40 Rs. 40
Yarn(thread) Rs. 70 Rs. 30
Cloth Rs. 115 Rs. 45
Shirt at tailor shop Rs. 165 Rs. 50
Shirt sold to consumer Rs. 200 Rs. 35
Total Rs. 590 Rs. 200

31. • From the example, it becomes clear that either we should count the value of
final product(shirt) only or we should take the value added at each stage of
production. If along with final product, the value of intermediate goods (yarn,
cloth, etc.) is included it would mean double (or multiple counting).
ii. Non-marketed production and unpaid services* is not included in the
estimation of national income. This is because of difficulty in finding their
correct value, e.g. services of housewives, self- gardening or self -shaving are
difficult to estimate in quantity and in money value.
*A lot of output is produced by our households such as baking, clothes making, laundry
etc. Most of these services are performed by housewives. We do not include such
output in national accounts---not because that we do not recognize the importance of
women’s work but because of our inability to find its correct money value. A restaurant
meal appears in GNP. But when you prepare an even better meal at home, only the
ingredients bought from the store are included. Thus GNP does not include some
important items, simply because they do not go through the market and cannot be
correctly measured.
iii. In order to measure all current output, we must include the market value of
any addition to inventories, i.e. the value of unsold goods or the goods which
are in the process of production.

33. Conclusion
It should be noted that if proper precautions rae observed, the
sum of values of all final productions, the sum of all incomes and
the sum of all expenditures will be the same. Thus the following
identity holds.
NATIONAL OUTPUT=NATIONAL INCOME=NATIONAL
EXPENDITURE
Output (O)= Income(Y)= Expenditure (E)