National Income

The total amount of goods and services which have been produced during the period of a year is called National Income (Fisher)

Concept of NI
Gross Domestic Product income generated or earned by the factors of production within the country from its own resources is called domestic income or domestic product. It includes: Wages and salaries Rents Interest Dividends Undistributed corporate profit including surpluses of public sector undertaking Mixed income consisting of profit of unincorporated firms, self-employed persons, partnerships etc. Direct taxes GDP = NI Net income earned from abroad

Gross National Product

GNP is the total measure of the flow of goods and services at market value resulting from current production during a year in a country including net income from abroad. It includes:
Consumer goods & services to satisfy the people Cross private domestic investment in capital goods Goods and services produced by the government Net export of goods and services GNP = GDP + Net Factor Income earned from abroad
Net Income from abroad = exports - imports

Net National Product

GNP includes the total value of output of consumption goods & investment goods. Some fixed equipment wears out, damaged or destroyed and other rendered obsolete. All this process is termed depreciation or capital consumption allowance. In order to arrive at NNP, we deduct depreciation from GNP. NNP = GNP - Depreciation

 NNP at Market Price is the net value of final goods and services evaluated at market price in the course of one year in a country NNP(mp) = GNP(mp) - Depreciation NNP at Factor Price it includes income earned by factors of production through participation in the production process such as wages & salaries, rent, profit etc.
NNP(FP) = NNP(MP) Depreciation Indirect Taxes - Subsidies

Personal Income
PI is the total income received by the individuals of a country from all sources before direct taxes during a year. PI is never equal to NI because the PI includes the transfer payments whereas they are not included in NI PI = NI undistributed corporate profile Profit Taxes Social Security Contribution + Transfer Payments + Interest of Public Debs

Disposable Income
Its the actual income which can be spent on consumption by individuals and families. To obtain DI direct taxes are deducted from PI. DI = PI Direct taxes

Real Income
Real income is NI expressed in terms of a general level of prices of a particular year taken as base. NI is the vale of goods & services produced as expressed in terms of money at current prices but it does not indicate the real state of economy.
Real NNP = NNP(current year) x Base Year Index / Current Year Index

Methods for Measurement National Income

National Income can be measured by following methods: National income at market price or output method National income at factor cost or income method Expenditure method

Market Price or Output Method

According to this method, value of all goods (agricultural, industrial, minerals, raw goods) and services (doctors, lawyers, engineers) of the country is taken in terms of money. The aggregate show the national income.
Example if price of cloth is taken than price of cotton should not be taken which is used in manufacturing of cloth.

Goods and Services Wheat Cotton Sugar Pulses Doctors Lawyers

Quantity 100 80 50 30 3 5

Price 50 100 100 50 5000 2000 Total

Market Value 5000 8000 5000 1500 15000 10000 44500

Difficulties and Precautions

In estimating NI at market price, only final products should be taken into account Goods and services rendered free of charge are not included The transactions which do not arise from the product of current year or which do not contribute in anyway to production are not included The profit or losses on account of changes in capital assets as a result of changes in market prices are not included Income earned or goods produced through illegal activities are not included

Income Method or Factor Earning Method

According to this method annual method of all the factors of production land, labour, capital, organization is taken and these aggregations shows the national income.

Sources of Income Wages of labour Interest of capital Rent of building and land Profit for the service of doctor, lawyer, teacher etc Income for the service Total

Amount in (billion) 300 50 170 80 100 700

Difficulties and Precautions

Expenditures on transfer of payments by government such as unemployment benefit, old age pensions, interest on public debt should also not be included because no productive service is rendered in exchange. The expenditure on second hand goods should not be included as they do not contribute to the current years production Expenditure on purchase of old shares and bonds is not included.

Expenditure Method
According to this method the national expenditure on goods and services is taken during the period of one year which represent NI. The following expenditure is taken for the measurement of NI:-

Sources of Income Private expenditure on consumer goods Public expenditure on consumer goods Private expenditure on investment goods Public expenditure on investment goods Total

Amount (in billion) 120 80 80 70 350

Difficulties and Precautions

Transfer payment such as gift, donations, scholarships and indirect taxes should not be included in the estimation of NI Illegal money earned through smuggling and gambling should not be included Windfall gains such as prizes, lotteries etc. is not included in the estimation of NI Receipts from the sale of financial assets such as shares, bonds should not be included.

Circular Flow of Income / Money

Production
The use of economic resources in the creation of goods and services for the satisfaction of human wants.

Consumption
The using up of goods and services by consumer purchasing or in the production of other goods.

Employment
The use of economic resources in production; engagement in activity

Income Generation
The production of maximum amount an individual can spend during a period without being any worse off.

Two Economic Units

Household
The basic consuming unit.

Firm
The basic producing unit.

Stock and Flow Variables

Flow
A quantity measured over a particular period of time.

Stock
A quantity measured as of a given point in time.

The concepts of stock and flow measurements are essential in understanding the economic variables of wealth and income.
Wealth
Anything of valued owned. It is a stock since it is what is owned at a particular time.

Income
The rate at which we earn money. It is a flow since income that is saved, increases the stock of wealth.

Economic Model of Production

The Circular Flow of the Production Process
ECONOMIC RESOURCES

HOUSEHOLDS

PRODUCING UNITS

GOODS AND SERVICES

Circular Flow of Goods Among Production Units

RAW MATERIALS

RAW MATERIAL FIRM

INTERMEDIATE GOOD FIRM

CONSUMERS INTERMEDIATE GOODS

FINAL GOODS

FINAL GOOD FIRM

Interrelation Between Production Units & Households

RESOURCES
RAW MATERIAL FIRM

HOUSEHOLDS

RESOURCES

INTERMEDIATE GOOD FIRM

RESOURCES

FINAL GOOD FIRM

Economic Model of Income and Consumption

The Circular Flow of Goods and Income Among Producers & Households
RESOURCES RAW MATERIAL FIRM

MONEY PAYMENT FOR RERESOURCES

RESOURCES

MONEY PAYMENT FOR RESOURCES HOUSEHOLDS RESOURCES

INTERMEDIATE GOOD FIRM

MONEY PAYMENT FOR RESOURCES MONEY PAYMENT FOR PURCHASE OF FINAL GOODS FINAL GOOD FIRM

FINAL GOODS

The Circular Flow of Income

INCOME FLOW OF WAGES, INTERESTS, RENTS

HOUSEHOLDS

PRODUCING UNITS

PURCHASES OF GOODS AND SERVICES

Circular Flow of Income Among Production Units

MONEY PAYMENTS FOR RAW MATERIALS

RAW MATERIALS FIRM MONEY PAYMENTS FOR INTERMEDIATE GOODS FINAL GOOD FIRM

INTERMEDIATE GOOD FIRM

MONEY PAYMENTS FOR FINAL GOODS

HOUSEHOLDS

The Circular Flow of Output and Income

Circular Flow of Physical Goods and Money Income
Goods and Services Factors of Production (land, labor, capital, entrepreneur)

Household Sector

Business Sector

Payments of Factors (rent, wages, interest, profit)

Payment of Purchase of goods and services.

The Circular Flow of Goods & Income of Households & Firms with the Government & Foreign Countries
GOVERNMENT

Wages, Transfer Payments

Taxes Economic Resources Taxes

Purchase of Goods & Services

Purchase of Goods & Services

HOUSEHOLDS Income Payments of Wages, Rent, Dividends, & Interests Goods & Services Money Payments for Imports FOREIGN COUNTRIES Money Payments for Exports PRODUCING UNITS

Implications of the Circular Flow of Economic Activity

1. The goods, resources, and money payments will flow as long as households continue to consume, and as long as firms continue to produce. 2. That since goods and resources flow in exchange for payments, the rate of payments flow will in the end be the same. Money is the inducing factor, and the pillar of the price system. Without it, there is no price system.

Inflows and Outflows

Outflows (factors that decrease the level of economic activity)
Savings Taxes Imports

Inflows (factors that increase the level of economic activity)

Investment Government Spending Exports

The Circular Flow of Economic Activity Reflecting The Outflows & The Inflows
Economic Resources Purchase of Goods & Services Income Payments of Wages, Rent, Dividends, & Interests Goods & Services IMPORTS TAXES SAVINGS Foreign Countries Government Banks EXPORTS EXPENDITURES INVESTMENTS

HOUSEHOLDS

PRODUCING UNITS

Outflows are difficult to control because they are dependent on income. When income increases, we expect savings, taxes, and imports to increase.
Inflows are easier to manipulate. The proper use of policy enables the government to encourage exports and investments and to increase its expenditures when it desires to expand the flow of economic activity.

The Deflationary & Inflationary Gap

Equilibrium GDP is the level of output at which aggregate demand equals aggregate supply
Aggregate demand is the sum of all expenditures for goods and services (that is, C + I + G + Xn) Aggregate supply is the nations total output of final goods and services So at equilibrium GDP, everything produced is sold
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

12-7

The Deflationary & Inflationary Gap

Full-employment GDP is the level of spending necessary to provide full employment of our resources
If our plant and equipment is operating at between 85 and 90% of capacity, thats full employment If only 5% of our labor force is unemployed, thats full employment

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

12-8

Deflationary Gap
The Deflationary Gap

When the full-employment GDP is greater than the equilibrium GDP, there is a deflationary gap.

9 8 7 6 5 4 3 2 1 2 1 2 3 4 5 6 7 8 9 Def lationary gap C + I + G + Xn

$1 trillion

Equilibrium GDP

Full-employ ment GDP

GDP (in trillions of dollars)

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

12-9

Deflationary Gap
Equilibrium GDP is less than full-employment GDP
Spending is too low Results in a deflationary gap

Measures to control
Increase in government expenditures Reduction in taxes to increase disposable income and profitability of business sector
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Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Inflationary Gap
The Inflationary Gap When equilibrium GDP is greater than fullemployment GDP, there is an inflationary gap.

2,000 C + I + G + Xn

1,500

Inf lationary gap

1,000

500

$200 trillion

0 500 1,000

500 1,500 2,000

Full-employ ment GDP

Equilibrium GDP

GDP (in trillions of dollars)

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

12-10

Inflationary Gap
Equilibrium GDP is above the full-employment GDP
Spending is too high Results in an inflationary gap

Measure to control
Expenditures on public administration Subsidies on non-merit goods Increase in cash reserve ratio Central bank reduce the availability of credit By reducing non-development government expenditures
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Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

What is Investment
investing: the act of investing; laying out money or capital in an enterprise with the expectation of profit money that is invested with an expectation of profit the commitment of something other than money (time, energy, or effort) to a project with the expectation of some worthwhile result; "this job calls for the investment of some hard thinking"; "he made an emotional investment in the work"

Determinants of Investment
Expected return Cost of capital in-terms of interest rate Availability of savings to meet investment Taxation Other important determinants: Risk appetites of investors Entrepreneurial skills Legal and institutional framework Protection of investors