Circular Flow of

National Income
ByAadya Sanskar
&
Abhinav Raj

National Income(GDP)
The market value of all final goods and

services produced within a country in a given

period of time Y = C+I+G+(X-M)
Y = GDP
C = Consumption
I = Investment
G = Government expenditure
(X-M) = Net export

National Income
It is regarded as the most

comprehensive measure of the

level of economic activity and
index of economic growth of an
economy.

What is National Income?

It is defined as the value of all final

goods and services produced by the

normal residents of a country,
whether operating within the
domestic territory of the country or
outside, in a year.

Final Goods & Services

These are sold to the final users during the year.

Finished goods for

final consumption and investment.

Final goods and services:
Food items, refrigerators etc. consumption
Machines, buildings etc. - Investment

Intermediate Products
These are used by the producers as

input into a further stage of

production.
Resold after converting into final

goods.
Seeds, fertilizers, etc.

Importance of National Income in

Economic development
Study of problem of disequilibrium
Effect of leakages and inflows
Link between producer and consumers
Create a network of market
Inflationary and deflationary tendencies
Basis of the Multiplier
Importance of monetary policy
Importance of Fiscal policy
Importance of Trade policy
Basis of flow of funds accounts

To measure NI accurately
All goods and services produced during a year

must be counted once, but not more than

once.
Intermediate products are excluded from NI.

i.e. flour mills sell flour to bakeries, and

bakeries use this flour in making breads which
are sold to households

Flow
NI is a flow concept. It is the flow of goods and

services. A flow is a quantity which is

measured over a period of time.
It tells us how many rupees worth of goods

and services are flowing in the economy per

unit of time.
Conventionally, NI is expressed over one year.

Current
Output

NI measures the value of currently produced

goods and services.

Excludes pure exchange transactions, such

as sale and purchase of second hand goods or

used goods, purchase and sale of securities
and transfer payments. Why? Because,
nothing new is produced in the current year.

Current Output
What to do with the value of the services

of the commission agents involved in the

second hand sales?
Regarding sale and purchase of financial
assets (both old and new) like bonds and
shares?
Services of the share brokers?
Transfer payments like social security
payments (pensions, etc.), donations and
gifts (unilateral payments).

Normal Residents
Those persons who ordinarily reside in a

country which they live and whose economic

interest lies in that country.
May or may not be the citizens of that
country, i.e. normal residents include national,
as well as foreign nationals.
They produce goods and services by selling
their factor services to production units
located within and outside the domestic
territory of a country.

Domestic Territory
Geographical or political boundary excluding

foreign embassies and international

institutions located within the geographical
territory, and including the embassies of this
country located outside its geographical
territory.
Domestic product: value o final goods and
services + NFI received from abroad
NI is not the sum total of personal incomes

Process of circulation of National

Income

Household Sector
Business Sector
Government Sector
Foreign Sector (rest of the

world sector)

THREE PHASES OF CIRCULAR FLOW

2. Income

1. Production

3. Expenditure

Involvement of Different Sectors in Circular Flow

1. The Producing Sector

3. The Government Sector

2. The Household Sector

4. Rest of the World Sector

Households / Resources
(Factors of Production)

LAND

CAPITA
L

LABOU
R

ENTREPRENEU
R

Circular Flow Model in two Sector Economy (Closed Economy)

Consumption Expenditure (Money Flow)

Producers/ Firms

Goods & Services (Real Flow)

Factor Services (Real Flow)

Factor Payments (Money Flow)

Households

Two Sector Model with Savings/Financial System

Factor Payments (Money Flow)
Goods & Services (Real Flow)

Borrowing for

Saving

Investment

Households

Producers/ Firms
Money / Finance
Factor Services (Real Flow)
Consumption Expenditure (Money Flow)

Two Sector equation

Y = C+S

(1)
Y = C+I
(2)
C = Consumption
I = Investment
S = Saving
From eq.(1) & eq.(2) C+S = C+I

I=S

The Circular Flow Model in three Sector Economy

Taxes

Taxes
Expenditure on Goods & Services

Borrowing

Government
Saving

Subsidies

Transfer Payments

Saving
Producers

Saving
Borrowing

Borrowing

Money / Finance
Factor Payments
Consumption Expenditure

Households

Three Sector equation

Y = C+S+T

(1)
Y = C+I+G
(2)
C = consumption, S = saving, T = tax,
I = investment, G = govt. expenditure
From (1) & (2) - C+I+G = C+S+T

I = S+(T-G)

The Circular Flow Model in four Sector Economy (Open

Economy)
Rest of the World

Saving

Government

Taxes

Borrowing

Transfer

Payments

Saving

Producers

Borrowing

Import

Payment

Export
Receipt

Ne
tT
ay rans
NP
et me fe
Pa Fac nts r
ym t o
en r
ts

Saving
Money / Finance

Borrowing

Govt. Consumption
Expenditure
Transfer Payments
Taxes

Households

Four Sector equation

Y = C+S+T+R

(i)

pf

= Payment to foreigner in terms of

import
pf

Y = C + I

+ G + (X-M)
f

N x = (X-M) = I
Net
expor
t

pf

+R

Foreign
investme
nt

gf

+R

Paymen
t
received
from
foreigne
r

cont
We know that

I = Id + fI

Foreign
investment

Domestic
investme
nt

Y = C + I
d

+I
f

+G + R
pf

gf

+R

(ii)

From (i) & (ii) -

I +d I =
S + T (G + gfR
f

Circular Flow of Income

Interaction and inter-dependence between

various economic activities like production,

exchange and consumption is called the
circular flow of income.
NI is a flow concept.
Production give rise to Income which gives
rise to Consumption/Expenditure and
expenditure gives rise to income again.
It goes on continuously and indefinitely in a
circular way; it has neither any beginning nor
any end.

Circular Flow of Income

Thus, CFI is defined as the flow of

payments and receipts for goods

and services and factor services
between different sectors of the
economy.
Flows:
Real Flows
Flow of factor services
Flow of goods and services
Money Flows

Leakages in the Circular Flow

Flow Variables which have negative impact

on the process of production in the economy.

Savings [S]

Imports [M]
Taxes

Injections in the Circular Flow

Flow Variables which cause expansion in

the process of production in the economy.

Investment [I]
Govt. Consumption Exports [X]
Expenditure [G]

The circular flow of income

INJECTIONS
Investment (I)

Factor
Payments

Consumption
of domestically
produced
goods &
services (Cd)

Export
expenditure (X)

Government
expenditure (G)
BANKS, etc

Net
saving (S)

GOV.

ABROAD

Import
Net
expenditure (M)
taxes (T)

Leakages

Circularity Never Stops

1. The discovery
of new resources

2.Innovative Technology both

in the areas of Production and
Management

Significance of the Study of

Circular Flow of Income
Knowledge of Interdependence
Identification of Injections &

Leakages
Estimation of National Income
Level and Structure of Economic

Activity

Conclusion
The first and foremost importance of national

Income estimate is that it gives us a correct picture

of the structure of economy as well as the correct
picture of the distribution of income . It will be easy
to access the trends in country economic growth and
also analyze the factor responsible for this trends.
National income estimate gives us an idea of the
purchasing power of the people in the country.
National income estimate gives central govt. to
formulate fiscal and monetary policy.
National income estimate gives govt. to imply its
public welfare program.

Thank You