This document discusses national income accounting and the circular flow of income in economies with different numbers of sectors. It begins by defining key concepts like GDP, the expenditure and income approaches. It then examines two, three and four sector economies, defining sectors like household, business, government and foreign. It provides equations to represent the expenditure and income components in each economy, like consumption functions, investment, taxes and transfers. Overall, the document provides an overview of national income accounting and circular flow models in different types of economies.

1. 1

2. 8/13/2022
2
 National Income Accounting Identity
 Two Sector Economy
 Three Sector Economy
 Four Sector Economy

3. National Income Accounting Identity
 Set of rules and definitions to measure economic
activity in the aggregate economy ie. in the
economy as a whole.
 National income accounting is a method of
measuring total, or aggregate production.
8/13/2022
3

4.  National income is the money value of all final output
of all economic activities of the people of a country.
 Macroeconomic analyses use different concepts
measures of national income- mainly Gross National
Product (GNP) and Gross Domestic Product(GDP).
8/13/2022 4

5. 8/13/2022
5
 In national income accounts, equality of
expenditure and income is denoted as the
national accounting identity.
 The identity can be seen in the circular
flow of income in an economy: income
must equal expenditure.
 Supply and demand determine market
equilibrium price and quantity in each
market.

6. The Economy’s Income and Expenditure
8/13/2022
6
 Gross Domestic Product (GDP) is a
measure of income and expenditure of an
economy in a given period of time.
 GDP measures:
• an economy’s total expenditure on newly
produced goods and services, or the total
income earned from the production of
these goods and services.

7.  Expenditure Approach
The summation of total expenditures incurred by
household, business and government sectors.
 Income Approach
The summation of the factor prices paid by the
business sector to household sector in return to the
resources/production factors purchased for
production.
8/13/2022
7

8.  The expenditure approach measures the
expenditures in product markets.
 Total demand for domestic output (GDP) is made
up of four components.
GDP = C + I + G + (X - M)
 Consumption spending by households (C)
 Investment spending by business and households (I)
 Government spending on the purchase of goods and services
(G).
 Foreign demand (Net Export) (NX)
8/13/2022
8

9.  Consumption (C)
 Consumption can be defined as the act of using goods and
services to satisfy one’s needs and wants.
 It consists of goods and services bought by households
and divided into three subcategories:
◦ Consumption of non-durable goods
◦ Consumption of durable goods, and
◦ Consumption of services.
 Consumption is a major part in aggregate expenditure as
well as a main determinant of national income.
8/13/2022
9

10. 8/13/2022
10
Investment (I)
 The act of producing goods and services
that are not for immediate consumption is
Investment. Ie. Business fixed investment ,
Inventory investment etc.

11. 8/13/2022
11
Government Expenditure (G)
 Government purchases are the goods and
services bought by the government.
 also a part of GDP.
 includes such items as highways, military
equipment, and services that government
workers provide.
 We assume that government expenditure on
goods and services are held constant.

12. Net Exports (NX)
 Net exports are the value of goods and services
exported to the rest of the world minus the value of
goods and services that rest of the world provide us.
8/13/2022
12

13.  Private consumption
 Investments
 Government Purchases
 Net Exports
8/13/2022 13

14.  Only two sectors in the economy, ie.
◦ household sector, and business sector
 Produces only two types of commodities, namely;
- consumer goods
- investment goods.
• assume that no government intervention and no
foreign sector involved in this economy.
8/13/2022
14

15. 8/13/2022
15
 In terms of aggregate expenditure, we have,
AE = C + I
 Households consume some of the economy’s
output.
 Firms and households use some of the output for
investment.
 Unsold output is also counted as part of
investment.
 Therefore total output is either consumed or
invested.

16.  Suppose consumption function and investment in a
two-sector economy are given as:
C=50+0.80Y, and
I= 50
 Find the equilibrium level of income, consumption
and savings.
8/13/2022 16

17.  Suppose structural equations of an economy are given
as follows.
Y=C+I
C=100+0.75Y, and
I = 100
Find the equilibrium values for Y and C.
8/13/2022 17

18. Government Expenditure
 Government expenditure is the third component of the
demand for goods and services in an economy.
 Government expenditure is treated as autonomous.
 The government is assumed to decide on how much it
wishes to spend in real terms, and to continue these
plans regardless of the level of national income.
Hence
 G = Go
8/13/2022
18

19.  The national income accounting identity is
as follows:
AE = C +I+G
8/13/2022
19

20.  In this model, government purchases
and Investment are taken as
autonomous or exogenous variables.
 To denote that these variables are fixed
(exogenous) of national income,
I = Io G = Go
 Hence, the national income accounting
identity in a three sector economy is,
AE = C + Io + Go
8/13/2022
20

21. Lump-sum Tax
8/13/2022
21
 A tax that collects the same amount of tax revenue
at each level of GDP is denoted as Lump-sum tax.
 When the government imposes a lump – sum tax, it
can be concerned as an exogenous variable and can
be denoted by To.
 It does affect the consumers’ disposable income,
e.g., national security levy

22. Income Tax
 Income tax is an endogenous variable.
 The amount of income tax does change in response
to changes in national income.
 Income tax also affect the disposable income
indirectly.
 Income tax collected by the government is noted as
tY, where 't' is the income tax rate and 'Y' is the
national income.
8/13/2022
22

23.  Thus total tax function consists of two
components:
◦ Lump-sum tax (To)
◦ Income tax (tY) paid by households.
 Therefore, total tax function (Tx) is,
Tx = To + tY
Where: T0 = Lump-sum tax, and
t = Income tax
8/13/2022
23

24. 8/13/2022
24
Tx = To + tY
T0
Slope = t
Tax
National Income
0

25.  Another type of government expenditure is transfer
payments to households, such as welfare for the poor
and social security payments for the elders.
 Transfer payments are not made in exchange of output/
goods and services.
 Therefore it is not included in G0.
 Transfer payments do affect the demand for goods and
services indirectly.
 Transfer payments are treated as autonomous variable.
Tr = Tro .
8/13/2022
25

26. 8/13/2022
26
0 National Income
Tr = Tro
Tr

27.  We define net tax as the total tax revenues
received by the government minus total transfer
payments made by the government.
 Let net tax be, T
T = Tx - Tr0
Where:
Tx = Tax, and
Tr0 = Transfer Payments
8/13/2022
27

28.  Disposable income is the net income
available for spending by households after
they receive transfers and pay taxes to the
government.
 It is the income that households can
actually spend from their income. Thus
Yd = Y - T
 Where Yd = Disposable Income, Y = Income, T =
Net Tax ( Tax – Transfer Payments )
8/13/2022
28

29.  Yd = Y –T
Where, T=Net tax
 T = Tx - Tr0
 Tx = T0 + tY
 Yd = Y – (T0+ tY - Tro )
 Yd = Y - T0 -tY + Tro
8/13/2022
29

30. Exports
 Exports depend on spending decisions made
by foreign consumers or firms that purchase
our goods and services.
 Therefore exports will not change as a
result of a change in our national income.
 Thus exports are autonomous or exogenous
expenditures from the point of view of our
national Income.
 X = X0
Where X = Exports
8/13/2022
30

31.  Imports depend on the spending decisions
of domestic residents.
 Hence it is denoted as
M = mY.
 Where M = Imports and
m = Responsiveness of imports to
national income, which is also called
"Marginal propensity to Imports".
 Here, m = M/Y, or in terms of calculus,
dM / dY
8/13/2022
31

32.  Net Exports can be derived as follows:
 NX = X0 - M
 X = X0
 M = mY
 NX = X0 - mY
8/13/2022
32

33.  The relationship between NX and national income
is the net exports function.
 The slope of the net export function is m, marginal
propensity to imports.
 It shows the impact of changes in income on the
level of imports.
 X0 , the level of autonomous exports is the
intercept of the net exports function.
8/13/2022
33

34.  When exports are less than imports, (X<M),
there is a balance of payments, (BOP), deficit.
 When exports are greater than imports,
(X>M), there is a BOP surplus.
 When exports equal imports, (X=M), BOP is in
equilibrium.
8/13/2022
34

35. Y = C + I+ G + NX
Where: Y = National Income, C = Consumption,
I= Investment , G=Government
Expenditure NX = Net Exports.
 Since I = Io, G = Go, NX = Xo - mY, national income
accounting identity in a four sector economy is:
Y = C +I0 +G0 +X0- mY
8/13/2022
35