The circular flow of income shows the continuous flow of payments between households and firms. Households supply factors of production like labor, capital, land and entrepreneurship to firms and receive factor payments in return, while firms produce goods and services and supply them to households in exchange for household expenditures. There are three main methods to calculate national income - value added method, expenditure method, and income method. The value added method sums the value added at each stage of production. The expenditure method sums consumption (C), government spending (G), investment (I), and net exports (X-M). The income method sums incomes from factors of production like wages, rent, interest, and profits.

1. Circular Flow of Income and Methods of Calculating National Income
What is Circular Flow ofIncome?
The circular flow means the unending flow of production of goods and services, income, and
expenditure in an economy. It shows the redistribution of income in a circular manner between
the production unit and households.
These are land, labour, capital, and entrepreneurship.
 The payment for the contribution made by fixed natural resources (called land) is known
as rent.
 The payment for the contribution made by a human worker is known as wage.
 The payment for the contribution made by capital is known as interest.
 The payment for the contribution made by entrepreneurship is known as profit.
Additional Reading: What are the Types of Banking
Circular Flow of Income in a Two-Sector Economy
It is defined as the flow of payments and receipts for goods, services, and factor services between
the households and the firm sectors of the economy.
Explanation

2.  The outer loop of the diagram shows the flow of factor services from households to firms
and the corresponding flow of factor payments from firms to households.
 The inner loop shows the flow of goods and services from firms to households and the
corresponding flow of consumption expenditure from households to firms.
 The entire amount of money, which is paid by firms as factor payments, is paid back by
the factor owners to the firms.
Methods of Calculating National Income
There are three known methods by which national income is determined. These are:
1. Value added method
2. Expenditure method
3. Income method
Let us look into the details of each of these methods.
Value Added Method
The value added method is also known as the product method or output method. Its primary
objective is to calculate national income by taking the value added to a product during the
various stages of production into account.
Therefore, the formula for calculating the national income by the value added method can be
expressed as:
National income (NI) = (NDPfc) + Net factor income from abroad
Expenditure Method
The expenditure method of national income calculation is based on the expenditures taking place
in the economy. The expenditures that happen in an economy can be done by individuals,
households, business enterprises, and the government.
Therefore, the formula for calculating the national income by the expenditure method can be
expressed as:
National income (NI) = C + G + I + (X – M)
Or
National income (NI) = C + G + I + NX
Income Method
The third method to calculate national income is the income method. It is based on the income
generated by the individuals by providing services to the other people in the country either
individually or by using the assets at disposal.
The income method takes the income generated from land, capital in the form of rent, interest,
wages and profit into consideration.

3. The national income by income method is calculated by adding up the wages, interest earned on
capital, profits earned, rent obtained from land, and income generated by the self-employed
people in an economy. It is known as net domestic product at factor cost or NDPfc.
The addition of the net factor income from abroad to the net domestic product at factor cost gives
the national income.
It can be expressed in a formula as:
NNPfc = (NDPfc) + Net factor income from abroad
3-4 marks questions
Q.1. What are the four factors of production and what are the remunerations to each of these known
as?
Answer
Explanation ● The productionofgoods andservices is the result ofthe combined efforts ofthe
following four factors ofproduction:
● Land, labour,capital,and enterprise
Factors of production remuneration
1. Land rent
2. Labourwage
3. Capitalinterest
4. Enterprise profit
Q.2. What do you understand by factor income? What are its broad categories?
Answer
(A) Meaning ● It refers to the income received by factors ofproduction forrendering factorservices in
the processofproduction.
(B)
Categories
● Factorincomes are broadly classified into fourcategories.Theyare:
Rent,wages,interest,andprofit.
Q.3. Differentiate real flow and money flow.
Answer
Basis Real Flow Money Flow
(a)
Meaning
It is the flow offactorservices from
householdsto firms,and the flow of goods
and servicesfromfirms to households.
It is the flow offactorpayments by firms to
households,and thepaymentforgoods and
services by households to firms.
(b) Medium (i) Factors Money

4. of exchange (ii) Goods and services
(c) Other
name
It is also known as physicalflow. It is also known as nominalflow.
Also know: Difference between Primary and Secondary Market
Q.4. Define the term ‘flow and stock’.
Answer:
Flow ‘Flow’ is a variable that is measured with reference to a period oftime.
Example: Flow of water in a river, income earned in a year,etc.
Stock ‘Stock’is a variable that is measured with reference to a particular point oftime.
Example: Waterin a tank,wealth,bankbalance on 31st March,etc.
Classify the following as stock and flow:
(a) Amount of bank deposits as on 31.03.2016 (b) Profit
(c) Losses (d) Capital
(e) Production (f) Population of India
(a) Amount of bank deposits as on
31.03.2016
‘Stock’, as these are related to a point oftime.
(b) Profit ‘Flow variable’, as the profit is measured overa period of
time.
(c) Losses ‘Flow variable’, as the losses are measured overa period of
time.
(d) Capital ‘Stock’, as the capitalis related to a point oftime.
(e) Production ‘Flow variable’, as the productionis measured overa period of
time.
(f) Population of India ‘Stock’, as the populationis related to a point oftime.
1 Mark questions
Define leakage.
Answer:
● It refers to the withdrawalof money fromthe circular flow of income.
● When householdsand firms save a part oftheirincome, it leads to a leakage from the circularflow of
income.
Define injections.
Answer:

5. It refers to the addition to the circularflowof income. Example: borrowings
Multiple choice questions
Q.1. The flow of goodsand servicesbetweenfirms and households are __________.
a. Real flow
b. Money flow
c. The flow of capital
d. Flow of stock
Q.2. Which ofthese belong to a two-sectoreconomy?
a. Firms and government
b. Householdsandgovernment
c. Householdsandfirms
d. Householdsandforeign sectors
Q.3. Which ofthe following is the consumption sector?
a. Government
b. Households
c. Firms
d. Foreign sectors
Q.4. Which ofthe following is not a flow?
a. Capital
b. Income
c. Investment
d. Depreciation
Answer Key:
1-a, 2-c, 3-b, 4-a
The above-mentioned concept is explained in detail about the Circular Flow of Income and
Methods of Calculating National Income. To know more, stay tuned to our website.
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