Ch 2

NATIONAL INCOME AND RELATED

AGGREGATES : BASIC CONCEPTS

AND MEASUREMENT

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1 An accounting period or a financial year often does not coincide with a calendar year. Ordinarily,a financial year refers to, for example, April 1, 2004 to March 31, 2005.

Macroeconomics, as pointed out earlier,deals with the study of aggregatesexpressed in terms of aggregate income,output, employment, expenditure,exports and imports and so on. In orderto determine the actual performancelevel of the economy, we need to followa framework of measurementprocedures to find these aggregates andeventually we must interpret themacroeconomic behaviour in terms ofmovements in these aggregatemeasures. National income accountingfacilitates the measurement of macroaggregates for a given economy.

Accounting is believed to be anecessary exercise for any economicunit to know its performance. Anindividual unit such as a Household ora Firm maintains its own accountinginformation since it is interested toknow its financial position at the end ofan accounting period.1 Importantdecisions concerning savings,

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CHAPTER 2

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investment and tax payments are allmade by the unit after an analysis ofthe accounting information availableto it.

At the macro level, accountingassumes an even greater significance asthe information is used for a review ofthe economy’s performance during theyear under study. On the basis of thisappraisal national governments have toformulate their policy programmes tomaximize the welfare of people. This isthe basic purpose of national incomeaccounting as it renders possible a setof procedures for measurement ofincome and output at the aggregatelevel. This means that we are, in fact,measuring the macroeconomic activitiesin the economy for a particular year.

Accounting for transactions byindividual units is relatively a lesscomplicated and a simple process ascompared to macro economicaccounting of aggregate output and

INTRODUCTORY MACROECONOMICS8

income for the economy as a whole. It isa rather difficult and complex procedureto quantify the macro variables foraccounting purpose. It is not adequateto merely look at the macroeconomicaggregates but it is also equallyimportant to learn the techniques ofmeasuring these aggregates. Therefore,national income accounting has evolvedas a branch of study in its own right.

Primarily, there are two basicfunctions of national income accounting:the first, is to identify specific economicachievements of a country and thesecond, is to provide an objective basisof evaluation and review of policiesunder implementation. Hence, nationalincome accounts data not only help usto measure macroeconomic aggregatesbut also enable us to understand,analyse and interpret the working of theeconomy as well. This is precisely thereason why the road map to the subjectof macroeconomics begin with a studyof national income accounting.

Uses of National Income Accounting

There are some principal uses ofnational income accounting. They maybe stated as follows:

1. National income accounting showsas to how the national income isshared among the various factorsof production;

2. National income statistics indicatethe specific contributions ofindividual sectors and their growthover time;

3. National income accounting helpsto find out structural changes in theeconomy.

4. National income accountingprovides the information forassessment of the economy’sstrengths and failures.

5. National income statistics enablecomparisons to be made in respectof standard of living, distribution ofincome and actual composition ofnational income over time.

6. National income accounts facilitatescomparison of output amongnations.

Hence, the national income data maybe viewed as a monetary manifestationof material results of human activity inthe economy. They provide standards bywhich economic achievement of policiescould be partly judged in modern times.

Structure of the Macro Economy

Circular flow2 of macroeconomicactivity

National income accounting calls for anunderstanding of the structure of themacro economy. The conceptual basisof measurement of national incomebegins with a depiction of the inter-related manner in which economicactivities are organised in an economy.A pictorial illustration of this inter-dependence between the major sectorsof economic activity is called the circularflow of income and product. This

2 Flow refers to change in an economic variable over time. Income and product are flow concepts.This may be distinguished from stock variable which means that there is no change over time.For example, wealth is a stock concept.

STRUCTURE OF THE MACRO ECONOMY AND NATIONAL INCOME ACCOUNTING 9

simply means that every economicdecision of a sector is in response to thatof another. Therefore, macro economyis in effect a system of interrelationshipsbetween the decision-makers in everysector of the economy.

The circular flow of income involvestwo basic principles:

(a) In any exchange process, the selleror producer receives the sameamount that the buyer or consumerspends; and

(b) Goods and services3 flow in onedirection and money payments toacquire these, flow in the returndirection, thereby causing a circularflow. So, the output or product orreal flow from the seller to the buyernecessarily creates the income orpayment or money flow from thebuyer to the seller.

We shall now explain this two-wayprocess of mutual dependence fordifferent sectors of the economy. This

3 A good is a tangible object (such as a can of fruit juice or a television) that has economicvalue. A service, on the contrary, is an intangible product (such as advertising) that haseconomic value.

Clip 2.1Circular Flow of Income and Product

The inspiration for the exposition of macro economy through a CircularFlow of Income and Product appears to have originated from the writingsof Physiocrats – a group of French economists who lived in 18th century.Physiocrats strongly believed in the existence of a natural order to guidethe working of the economy and hence according to them, there should notbe any kind of intervention by the Government in economic activities. Theyadvocated the policy of Laissez faire which means non-interference orminimal interference of the governments in trade and other economicactivities and accorded primacy to agriculture as such. Prominent amongthe Physiocrats was Francois Quesnay who propounded what is called the‘Tableau Economique’ in 1758. This economic table contains the conceptof circulation of wealth and a schematic presentation of the distribution ofagricultural output between all classes of society. Though this economictable was recognised as the ‘crowning achievement’ of Physiocrats, thistable was not explained by Adam Smith or those belonging to the classicalschool of economics. It was Karl Marx who rediscovered this table in themid-19th century.


4 Firms may produce either producer goods (capital goods used for making other goods) or consumergoods that is, goods meant for only consumption as such. Consumer goods can further beclassified into ‘durable’ and ‘non-durable’ variety depending upon whether they have short orlong span of life in their use to the consumers. A washing machine or an air-conditioner may becalled durable good while food items will fall under the category of non-durable or perishablegood, as they do not last long.

would be a helpful pre-requisite tounderstand the concepts used in theaccounting of national income as such.

Circular Flow in a Simple Two-sectorModel

To begin with, let us make the followingassumptions with regard to a simpleeconomy with only two sectors ofeconomic activity.– There are only two sectors in the

economy, namely, Households andFirms.

– Households supply factor servicesto Firms.

– Firms hire factor services fromhouseholds.

– Households spend their entireincome on consumption.

– Firms sell all that is produced to theHouseholds.

– There is no intervention ofgovernment or foreign trade.

Such an economy as described abovehas two types of markets. First, marketfor goods and services – Productmarket; and second, market for factorsof production – Factor market.

The economic interdependencebetween Households and Firms in thissimple economy can be observed asfollows:

(i) Household sector has theendowment of factors of production(land, labour, capital andentrepreneurial ability) and sellthem to the Firms that producegoods and services, using thesefactor inputs. The Firms, in turn, sellgoods and services thus produced4

to the Household sector for itsconsumption. Therefore, whateverthe Firms produce, is consumed bythe Households.

This type of interactionbetween Firms and Householdscan be described as the real flows,as it involves flow of goods andservices.

(ii) Exchange of goods and servicesbetween Households and Firms inresponse to acquiring factor servicesfrom Households corresponds toflows of income and expenditure ofthese two sectors. That is, Firms paythe Households in the nature ofwages for labour services, interestfor capital, rent for land and profitsto entrepreneurship. These arecalled factor payments by Firmsand factor incomes by Households.This income, in turn, is used byHouseholds to incur expenditure onbuying consumer goods andservices produced by firms.


This flow of money paymentsand expenditure can be described asmoney flows.

So, in the circular flow diagram(Fig. 2.1), we can recognise two realflows and two money flows.

As a result we can derive the following,in the case of our simple economy:1. Total production of goods and

services by firms = Totalconsumption of goods and servicesby Household Sector

PRODUCT MARKET

FACTOR MARKET

Mon

ey

Valu

e ofoutput = Expenditure on final goods and

services

Final goods and services

Factor Services : land, labour, capital, entrepren

eurs

hip

Total i ncome = rent +wages+interest+profits

HouseholdsFirms

Fig 2.1: The Circular Flow of Income in a Two-sector Economy

2. Factor Payments by Firms =Factor Incomes of HouseholdSector

3. Consumption expenditure ofHousehold sector = Income of Firmsector

4. Hence, Real flows of production andconsumption of Firms andHouseholds = Money flows ofincome and expenditure of Firmsand Households


This simple circular flow highlightsthe following interrelationships between:– Factor Market and Product Market– Output flow and Income flow– Business production and

Consumer spendingEach sector is seen in its dual role:

that of the buyer and seller. Thisperpetuates the circular flow betweenthe two sectors.

Circular Flow of Income withFinancial System

A wide variety of financial institutionsand markets constitute the financialsystem5 in our economy. Financialinstitutions are primarily intermediariesbetween savers and investors, or lendersand borrowers. They are specialise intheir respective areas of financialfunction. Development economists pointout the significance of financialdevelopment of an economy as aconcomitant outcome of economicdevelopment. Therefore, understandingthe macroeconomic activity will beincomplete without the inclusionof financial system in our circularflow model.

So far, in our presentation of circularflow of income, we have not consideredthe role of saving and investment. Thisis mainly due to the reason that wehave assumed that the two sectors –Households and Firms are balancedspenders (that is, they neither have asurplus nor deficit). Once we relax thisassumption a financial system to which

Households and Firms can lend andfrom which they can borrow wouldbecome relevant.

Households are the net lenders.This is possible due to generation ofpersonal savings, which is the differencebetween household income andconsumption. Firms are net borrowerssince they have to finance newinvestment in plant and equipment. Alllendings and borrowings arechannelled through the financialsystem. So long as lending is equal tothe borrowing, that is, leakage is equalto the injection, the circular flow willcontinue indefinitely (Fig.2.2).

Financial institutions pay interest tothe savers as their funds are placed withthem for a period of time under acontract. Firms pay dividend andinterest for the sums they have borrowedfrom the financial markets in the form ofshares, bonds and public deposits.Financial institutions, through their roleof intermediation, enable funds transferfrom ultimate lenders to ultimateborrowers. Saving and investmentprocess create better prospects for capitalformation, thanks to the operations offinancial institutions and markets.

Financial system is therefore veryimportant to the working of the moderneconomy. But it is sometimes believedthat money and finances are only acover over the production of goods andservices. But we cannot dismiss the

5 Here we assume that Households and Firms save part of their income, which constitutes a leakagefrom the circular flow of income. The saved amount is made available in the financial system. Firmsborrow for purposes of investment, which becomes injection into the circular flow.


funds flow between sectors asunimportant. Finance as someeconomists have held, is only a‘lubricant’ that makes the economy towork smoothly.

Circular Flow of Income withGovernment6

Whatever has been presented in theforegoing section leads us to theconclusion that under the two-sectormodel, the value of total output flow inour simple economy is equal to the totalvalue of factor incomes and the valueof personal consumption flow. Let usnow expand the two-sector model andobtain a three-sector model with the

inclusion of the Government sector.Economic interrelationships betweenHouseholds and the Government on theone hand and Firms and Governmenton the other are very important fromthe point of view of the role ofGovernment as regulator and as anagent of promoting general welfare ofthe people of the country.

All the changes which arenecessitated by inclusion of Governmentsector are shown in Fig. 2.3. In order tomake the analysis simple, now onwardswe will see only monetary flows.

Government purchases goods andservices from Firms and labour servicesfrom Households. Government collects

PRODUCT MARKET

FACTOR MARKET

Money value of final goods and services

Final consumer goods and services

Factor Services

Factor Payments

Savings

FinancialSystemFirms Households

Savings

Borrowings Borrowings

Fig 2.2: Circular Flow of Income in a Two-sector economy with Financial System

6 Government purchases of goods and services are included in the circular flow. Other flows includetax payments by households to government and transfer payments by governments to households.


taxes from Households and Firms inorder to finance its expenditure. Thegovernment makes transfer paymentsto the Households in the form of socialsecurity, scholarships, etc. It also givessubsidies to the Firms for variouspurposes. In India, subsidies are givento small industries, export units, andother priority sectors of our economy.7

Circular Flow of Income withExternal Sector

We now need to study the internationaldimension of macroeconomic activitybecause international economicenvironment affects output andemployment in the domestic economy.

The external sector is also called theRest of the World (ROW) sector and this

is connected with circular flow ofdomestic economy (Fig. 2.4). Thedomestic economy and the rest of theworld are connected throughinternational trade and capital flows.One country’s exports are anothercountry’s imports. This import andexport of goods and services ultimatelydecide what the domestic economygains or loses in the international trade.Home economy enjoys a trade surpluswhen there is excess of exports overimports; it suffers a trade deficit whenthe opposite happens.8

The four -sector model of theeconomy demonstrates the overallmacro economic condition of incomeand output in the following identity:

7 All taxes are leakages and all government expenditures are injections into the circular flow.8 Note that imports are leakages and exports are injections into the circular flow of income in the economy.

Bor

row

ings

Savings

Borrowings

Savings

GovernmentSector

FirmsFinancialSystem Households

Gov

ernm

ent Purch

asesTa

xes

Subs

idies

Payments for services

Taxes

Transfer PaymentsFacto

r Payments

Savin

gs

Consumption Expend iture

Borrowings

Fig 2.3: The Circular Flow of Income in a Three-sector Economy


SUMMARY

� Structure of the macro economy is given by the circular flow of income andoutput.

� National income accounting has its foundation in the circular flow model.� National income accounting has several uses for economic policy and

research.� Circular flow of income can be depicted in two-sector, three-sector and

four-sector models.� National income accounting provides the standards by which economic

activity of a country could be assessed.

Fig 2.4 : The Circular Flow of Income in a Four-sector Economy

Savings

Borrowings

Savings

Bor

row

ings

Gov

er

nmen

t Purchases

Taxe

s

Su

bsidies

Payments for Services

TaxesTransfer Paym

entsFacto

r Payments

Savin

gs

GovernmentSector

FirmsFinancialSystem Households

ExternalSector

Consumption Expend iture

International Transfe

r Inco

meR

eceipts for Expert s

Paym

ents for Import s

Inte rnational

Fact

or

Incom

e

(Net)

Borrowings

Y ≡≡≡≡≡ C + I + G + (X – M)Wherein

Y = Income or outputC = Private Consumption Expenditure

on Consumer goodsI= Investment expenditure by

Producing sectors

G = Government Purchases

X – M = Net exports (Where, X = Exports,M = Imports)

The science of national incomeaccounting is based on this identity.


EXERCISES

1. What are the uses of national income accounting?2. What is the principle of circular flow of income and product?3. Explain the circular flow in two-sector economy.4. Explain the circular flow in three-sector economy.5. Explain the circular flow in four-sector economy.6. With the help of a circular flow model, show that income and product

flows are equal.7. Explain the concepts of ‘leakages’ and ‘injections’ in the circular

flow of income.

Ch 2

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