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1. National Income Accounting:
Circular flow of income and expenditure
Economy represents the interrelationship between production, consumption and distribution
of goods and services. Economy shows the aggregation of all economic activities. Goods and
services are exchanged from one sector to another sector in an economy. There is flow of
money in opposite direction of flow of goods and services. Household sector provides factors of
production to the business sector whereas business sector provides goods and services to the
household sector. Household sector earn income from factor of production and expenses to
buy goods and services. Business sector earn income from goods and services and expenses to
buy factors of production. Thus, there is circular flow of income and expenditure in an
economy.
The circular flow of income and expenditure refers to the process whereby the national income
and expenditure of an economy flow in a circular manner continuously through time.
Circular flow of income and expenditure in a two sector economy
There is household and business sector in a two sector economy. There is no government and
foreign sector. It is not possible in real world. But this hypothetical economy gives the simple
ways to understanding the circular flow of income and expenditure. It is also known as two
sector closed economy. Household sector provides factors of production to the business sector
whereas business sector provides goods and services to the household sector. Household
sector earn income from factor of production and expenses to buy goods and services. Business
sector earn income from goods and services and expenses to buy factors of production.
Assumptions
i. There are only two sectors in an economy, household and business sector.
ii. No government and no foreign trade.
iii. All income should be spent
iv. All factors of production are taken from household to business sector.
v. All goods and services are taken from business to household sector.

2. Factor payments
Wages, Interest, Rent and Profit
HouseholdSector Production Sector
Services of land Labor, Capital etc.
Goods and Services
Price of Goods and Services
Circular Flow of Income and Expenditure in Two Sector Economy
Financial Sector
Saving Investment
The figure shows the circular flow of income and expenditure in a two sector economy. The
upper part of figure shows that the flow of income towards household sector due to the flow of
factors of production to business sector. Business sector expenses money to buy factors of
production. The lower part of figure shows that the flow of income toward the business sector
by selling goods and services to household sector. The household sector expenses money to
buy goods and services. The arrowheads show the flow of goods and services, income and
expenditure in the economy.
Circular flow of income and expenditure in three sector economy
Three sector of economy consist of household sector, business sector and government sector.
There is no foreign sector. This is also called three sector closed economy. The government
influences the level of economic activities in various ways; fiscal policy, monetary policy,
industrial policy, labour policy, price policy etc. This sector is more realistic than two sector
economy.
Assumptions
i. There are three sectors in the economy, household, business and government sector.
ii. Government intervention.
iii. Government imposes the tax.
iv. Government provides subsides to both household sector and business sector.
v. Household sector pay direct tax to government sector.

3. vi. Business sector pay direct tax and indirect tax to government sector.
vii. The economy is closed.
Production
Sector
Household
Sector
Government
Sector
Factor Services
Goods and Services
Factor Payments
Price of Goods and Services
Direct Income Tax
Wagessalaries and
Transferpayments
Direct and
IndirectTaxes
GovernmentPurchases
and Subsidies
Circular Flow of Income and Expenditure in three Sector Economy
The figure shows the circular flow of income and expenditure in three sector economy. The
circular flow of income and expenditure between household sector and business sector is
shown in lower part and upper part of the figure which is same as two sector economy. Upper
part of figure shows the income and expenditure of government sector in an economy.
Government sector purchases goods and services produced by business sector and imposed
direct tax and indirect tax. Government sector also provides subsidies to business sector.
Similarly, government imposed direct tax to household sector and provides wages, salaries and
transfer payments to household sectors.
Circular flow of income and expenditure in a four sector economy
Four sector economies include household, business, government and foreign sector. This is also
known as open economy. Foreign sector consist net export. Net export is the difference
between export and import.
Assumptions
i. Four sector includes household, business, government and foreign sector.
ii. No restriction of export and import.
iii. Competitive both internal and external markets.

4. iv. Well managed financial market.
v. Minimum government intervention
vi. Households export only labour and capital.
vii. Business firms export and import only goods and services.
Production
Sector
Household
Sector
Government
Sector
Factor Services
Goods and Services
Factor Payments
Price of Goods and Services
Direct Income Tax
Wagessalaries and
Transferpayments
Direct and
IndirectTaxes
GovernmentPurchases
and Subsidies
Circular Flow of Income and Expenditure in Four Sector Economy
Foreign
Sector
Foreign Remittance
Export of capital
and manpower
Receiptsfrom exports
Paymentsto Imports
The figure shows circular flow of income and expenditure in a four sector economy. The circular
flow between household, business and government sector is same as three sector economy.
The lower part of figure shows the circular flow of income and expenditure between foreign
sector and other sectors. Foreign sector consists export and import. Exports are an injection or
inflows in to the economy. They create income for domestic firms. On the other hand imports
are leakages from the circular flow.
The household sector buys goods imported from the abroad and makes payment for them
which is a outflows of income from circular flow. The household sector receives payment
(remittance) from the foreign sector for the export of capital and manpower.
The business sector exports goods to foreign countries and its receipts are an injection in the
circular flow. On the other hand, the business sector makes payments to the foreign sector
form import of capital goods, raw materials and other goods and services from abroad. They
are leakages from the circular flow.
Like the business sector, the government also receives payments from the foreign countries in
the form of subsidies, tourism, etc, they are injections. On the other hand the leakages are
payments made for the purchase of goods and services to foreigners.

5. The arrowhead shows the outflow and inflows of income and expenditure in four sector
economy.
National income accounting
It is a systematic record of aggregate economic activities of a country in the specific period of
time normally one year.
Importance/Usefulness
i. It provides a snapshoot picture of the economy which shows the overall status of the
economy.
ii. It shows the sectoral contribution to the economy.
iii. It works as the databank of the economic activities which can be used for policy making
purpose and academic research.
iv. It helps to make the international comparison of the domestic economy.
v. It gives the information of inflationary and deflationary gap.
National Income of an economy is the total market value of all final goods and services
produced in the economy over a certain period of time (normally one year).
National income is the sum of the income of all individuals in an economy in a given time
period.
National income is the aggregate earnings of the domestic factors of production in the specific
period.
National Product: It is the unduplicated market value of final goods and service produced by
domestic factors of production within one year.
Concepts of NIA:
Gross Domestic Product (GDP): Aggregate monetary value of final goods and services produced
within the country no matter who produces in a specific period of time (normally one year). It
only measures the final goods and services that are available in the market. So, It avoids double
counting.
It helps to know internal production capacity of economy. It helps to make comparison
between the two economies. It is computed in order to identify the performance of an
economy.
GDP = P1Q1 + P2Q2 + ...... + PnQn
Pi = Price of final product
Qi = Quantity of final product
GDP = ∑ Q
𝑛
𝑖=1 iPi

6. Pi = Price of ith commodity for final consumption
Qi = Quantity of ith commodity for final consumption
GDP = C + I + G + (X - M)
Where, C = Consumption expenditure
I = Total private investment
G = Government expenditure
( X - M) = Net export of goods and services.
Concept of GDP:
i) GDP at market price (GDPMP) :
If GDP of an economy is computed in terms of current market price then it is called GDP at
market price.
So,
GDPMP = ∑ Q
𝑛
𝑖=1 iPi
Pi = Current market Price of ith commodity
Qi = Quantity of ith commodity
GDP at market price is not practicable to compare GDP of two different years. It is because the
value of GDP may increase without increasing in volume of goods and services but increasing in
price level only.
ii) GDP at constant price (GDPCP):
If GDP is computed by considering price of the product in base year then it is called GDP at
constant price.
GDPCP = ∑ Q
𝑛
𝑖=1 iPi
Pi = Price of ith commodity during base year
Qi = Quantity of ith commodity
iii) GDP at Factor cost (GDPFC):
Gross domestic product at factor cost consists of income earned by a factor of production,
which is used in the production process.
GDP at FC = GDP ar MP - Net indirect taxes
Net Domestic Product (NDP):

7. NDP is the residual part of GDP after deducting depreciation. There exists wear and tear of the
machineries and other fixed factor of production while producing goods and services during a
year. Once we deduct such depreciation of capital during one year from GDP then we get NDP.
NDP = GDP - depreciation
NDPMP = GDPMP - depreciation
NDPFC = GDPFC - depreciation
NDPFC = NDPMP - Net indirect taxes
Net indirect taxes = Indirect taxes - Subsidies
Depreciation is the consumption of fixed capital or capital consumption allowance. It is also the
value of the capital that wears out.
Gross National Product (GNP):
It is aggregate monetary value of final goods and services produced by the domestic factors of
production no matter wherever they produce (inside or abroad) in a year.
GNP = GDP + earning by domestic factors of production from abroad - payments to foreign
factors of production
GNP = GDP + Net factors income from abroad (NFIA)
If GNP of an economy is computed in terms of current market price them it is called GNP at
market price.
If GNP is computed by considering price of the product in base year then it is called GNP at
constant price.
Gross National product at factor cost consists of income earned by a factor of production,
which is used in the production process.
GNPMP = GDPMP + NFIA
GNPFC = GDPFC + NFIA
GNPFC = GNPMP - Net indirect taxes
Net indirect taxes = Indirect taxes - Subsidies
Differences between GDP and GNP
i. GDP is the aggregate monetary value of final goods and services that is produced within the
country no matter who produces in a specific period of time whereas the GNP is the aggregate
monetary value of final goods and services produced by the domestic factors of production no
matter wherever they produce (inside or abroad) in a specific period.
ii. GDP measures the internal production capacity of the economy whereas GNP measures the
external dependency of the economy.
iii. GDP does not include NFIA whereas GNP includes NFIA.
iv. It is believed that GDP is a conventional indicator of NIA than GNP.

8. v. GDP is a narrow concept whereas the GNP is a boarder concept.
Net National Product (NNP):
NNP is the GNP with the cut off depreciation of capitals. There exists wear and tear of the
machineries and other fixed factor of production while producing goods and services during a
year. Once we deduct such depreciation of capital during one year from GNP then we get NNP.
NNP = GNP - depreciation
NNPMP = GNPMP - depreciation
NNPFC = NNPMP - Net indirect taxes
NNPFC = NDPFC + NFIA
National income:
It is the aggregate earnings of the domestic factor of production in the specific period of time.
NI = NNPFC
NI = NNP - indirect taxes + subsidies
NI = wages + rent + interest + profit
Personal income:
Personal income can be defined as the sum of all kinds of income received by the individuals
from all possible sources before payment of direct taxes during a year.
PI = NI - Undistributed profit - Corporate income taxes - Social security contribution + transfer
payments
Disposable Personal Income:
Disposable income is that part of the personal income which is ready to expenses. It refers to
the purchasing power of the individual or household. The total income received by all
individuals and households of a country from all possible sources after payment of direct taxes
is called disposable income.
DPI = PI - Direct tax (personal tax)
DPI = C + S
Personal Saving = DPI - personal consumption expenditure
Per Capital Income (PCI):
It is the average income of the peoples of a country in a particular year. It is the national
income divided by total population by country within a particular year.

9. PCI = NI/ Total population
Nominal GDP:
It is defined as the GDP evaluated at current market price.
Real GDP:
It is defined as the GDP evaluated at the market prices of any base year.
GDP deflator:
GDP deflator measures relative changes in current level prices in comparison to the level of
prices in the base year.
GDP deflator = Nominal GDP/Real GDP X 100
Rate of inflation:
Inflation rate is the ratio between change in deflator and previous GDP deflator.
Rate of inflation = change in GDP deflator / previous GDP deflator X 100
= Current GDP deflator - previous GDP deflator / Previous GDP deflator X 100
Measurement of National Income:
Production of goods and services gives rise to income, income gives rise to demand for goods
and services, demand gives rise to expenditure, and expenditure gives rise to further
production. Thus, there is circular flow of production, income and expenditure. Based on these
three related flows, national income can be measured by three methods. Product method,
income method and expenditure method which are explained below:
Product Method:
Product method measures national income at the phase of production in the circular flow.
Under this method, there are two approaches to the estimation of national income: i) final
product approach & ii) value added approach.
Final Product Method:

10. In the final product method, national income is estimated by finding the market value of all
final goods and services produced in an economy in a year. The various steps to the estimation
or calculation of national income according to this method are as follows:
GDP at MP = Market value of all final goods and services in the country
= P1Q1 + P2Q2 + ....... + PnQn
GNP at MP = GDP at MP + NFIA
NNP at MP = GNP at MP - depreciation
NI = NNP at FC = GNP at MP - Net indirect tax
Value added Method:
In this method the whole economy is classified into different sectors and the value added in
each sector is calculated. The value added means the difference between selling price and cost
of production or cost of intermediate goods.
i.e
Value added = sales value - cost of intermediate goods
Then we add all the value addition from each sector which gives the value of GDP.
GDP = V1 + V2 + ...... + Vn
Net value added is calculated by subtracting depreciation from gross value added.
Net value added = Gross value added - depreciation
NDP at FC = Sum of Net value added in all sectors
NI = NNP at FC = NDP at FC + NFIA
Income Method:
In this method or approach, the economic activities are measured from the income side.
Income means the earnings of the factors of production. So, the total income is classified into
following categories
i. Wages, salaries and other compensation to labour or labour's income (W).
W = Wages & salaries + Labour's contribution to social security + bonus + money value of other
facilities
ii.Rent (R): Nepalese rental income; land, building, factory etc.
iii. Interest (I): Interests received from the capitals are included in the national income.

11. iv. Profits ( P) : It includes dividends, profit tax and undistributed profits.
P = Dividend + Undistributed profit + corporate income tax
v. Mixed income and income from self-employment (M): Income earned by self employed
persons and profit of small business or sole proprietorship or household industries is included
in national income.
vi. Net indirect tax (NIT): It is the indirect tax less subsidies.
NIT = indirect tax - subsidies
vii. Net factor income from abroad (NFIA) : It is also included in the national income.
viii. Depreciation (D): The depreciation amount is deducted from gross income to get net
income.
NDP at FC = W + R + I + P + M
NI = NNP at FC = NDP at FC + NFIA
Also,
GDP at MP = W + R + I + P + M + D + NIT
GNP at MP = GDP at MP + NFIA
NNP at MP = GNP at MP - D
NI = NNP at FC = NNP at MP - NIT
Expenditure Method:
We can measure every economic activity from the perspective of expenditure. Since, every
economic activity is related with some expenditure we broadly classify the whole expenditure
in the economy in to following 4 categories.
i. Consumption expenditure made by household (C):
It includes the total expenditure made by the household which can be the expenditure on
durables, non-durables and services of all kinds.
ii. Expenditure made by business sector (I):
It includes the expenditure made by business sector on capital goods. The capital goods can be
divided into machinery and equipment, buildings and inventory investment. It includes
residential investment, non-residential investment and change in stock.
I = residential investment + non-residential investment + change in stock
In another way, it also as
I = Net fixed capital formation + depreciation + change in stock
Change in stock (Change in inventories) = closing stock - opening stock
iii. Government expenditure (G): It includes all the expenditure made by government on goods
and services in the year. It includes government consumption expenditure and government
investment expenditure.

12. G = government consumption expenditure + government investment expenditure
iv. Net export (X-M):
Since GDP measures the value of domestic product only the exports are added while imports
are to be subtracted to get the value of products produced within the country.
By adding all the components we get value of GDP.
GDP at MP = C + I + G + (X-M)
GNP at MP = GDP at MP + NFIA
NNP at MP = GNP at MP - depreciation
NI = NNP at FC = NNP at MP - Net indirect tax
Limitation/Problems/Difficulties in measurement of national income
i. Problem of double counting: Double counting is a major problem in the calculation of national
income. It refers to a commodity being included to the calculation of national income more
than once. To solve this problem, only the value of final goods and services should be
considered.
ii. Illegal income: Income earned through illegal activities (such as gambling, smuggling etc) is
not included in national income. By excluding such activities national income is underestimated.
iii. Existence of non-monetized sector: Existence of non-monetized sector poses another
difficulty in the way of national income calculation. All goods are not come to the market for
sale. Thus, it is difficult to include all goods and services in national income accounting.
iv. Non - availability of reliable data: National income measurement requires correct and
reliable data. But it is very difficult to get reliable data in developing countries and developed
countries also.
v. Lack of skilled manpower: National income measurement requires skilled manpower. But in
developing countries there is lack of skilled manpower.
vi. Complication of calculation of depreciation: Depreciation is deducted from Gross National
product to get the net national product. But, depreciation valuation involves statistical
difficulties like the age composition of the capital stock, year to year changes in the price of
capital goods since when they were purchased.
vii. Change in value of money: National income is measured in monetary terms. The change in
value of money creates the problem to calculate national income because national income
changes even without change in output.
Formula
1. GDP at MP = P1Q1 + P2Q2 + ...... + PnQn
2. GDP at MP = C + I + G + (X - M)
3. GDP at FC = GDP at MP - NIT
4. NIT = Indirect tax - subsidies

13. 5. NDP at MP = GDP at MP - depreciation
6. NDP at FC = NDP at MP - NIT
7. GNP at MP = GDP at MP + NFIA
8. NFIA = Earnings of domestic factors of production from abroad - payment to foreign sectors
9. GNP at FC = GNP at MP - NIT
10. NNP at MP = GNP at MP - depreciation
11. NNP at FC = NNP at MP - NIT
12. NI = NNP at FC
13. PI = NI - undistributed profit (Retained earnings) - social security contribution - corporate
income tax + transfer payment
14. DPI = PI - direct taxes (Personal taxes) OR DPI = C + S
15. Per Capita Income = NI/total population
16. GDP deflator = Nominal GDP/Real GDP X 100
17. Rate of inflation = Change in GDP deflator/previous deflator X 100
18. Value added = Value of output - cost of intermediaries (purchases)
19. Value of output = Sales + Change in stock
20. GDP at MP = sum of value added
21. Net value added = value added - depreciation
22. NDP at FC = Sum of net value added
23. NDP at FC = W + R + I + P + M
24. GDP at MP = W + R + I + P + M + depreciation + Net indirect tax
25. W = wages & salaries + labor's contribution to security + bonus + money value of other
facility
26. P = Dividend + Undistributed profit + corporate income tax
27. I = Net fixed capital formation + depreciation + Change in stock
28. Change in stock = closing stock - opening stock
29. G = Government consumption expenditure + Government investment expenditure
30. Operating Surplus = Rent + Profit + Interest + Royalty
31. Value of output in government sector = value of service sold + value of service supplied