Economics (Module-2)

The circular flow model demonstrates how money moves through

society. Money flows from producers to workers as wages and flows
back to producers as payment for products. In short, an economy is an
endless circular flow of money.

That is the basic form of the model, but actual money flows are more
complicated. Economists have added in more factors to better depict
complex modern economies. These factors are the components of a
nation's gross domestic product (GDP) or national income. For that
reason, the model is also referred to as the circular flow of income
model. The basic purpose of the circular flow model is to understand
how money moves within an economy. It breaks the economy down
into two primary players: households and corporations. It separates
the markets that these participants operate in as markets for goods and
services and the markets for the factors of production. Other sectors
can be added for more robust cash flow tracking.

The circular flow model is used to measure a nation's income, as the

circular flow model measures both cash coming into and exiting a
nation's economy. It is also used to gauge the interconnectivity
between sectors as a fully robust and strong economy will have
interaction between components. For instance, the relationship
between a government's taxation policies and a household's
consumption spending will have a direct impact on a business's ability
to sell goods.

Circular Flow of Income in a Two-Sector Economy:

Assumptions:
1. Only 2 sectors i.e. households and firms
2. No government intervention
3. Closed economy
4. No savings
5. No investment spending by firms
In real flow Factors of production flows from households to firms and
commodities/services flow from firms to households.
In monetary flow, Factor payments flow from firms to households and
Consumption expenditure flows from households to firms.

Circular Flow Of Income in a Three-sector Economy:

Assumptions:
1. Closed economy
2. No international trade
3. Government intervenes by collecting taxes and providing goods
and services
4. Excludes financial sector

The government also plays a crucial role in the economic

development of a country. Therefore, the circular flow of income in a
three-sector economy includes households, firms, and the government
sector. The government of a country acts as both a firm and a
consumer. As a firm or producer, the government produces goods and
services for the economy. However, as a consumer, it spends money
on the consumption of goods and services produced by the firms.
Besides the flows of circular income in the two-sector economy with
a financial market, the additional flows due to the inclusion of the
Government are:
1. Between Households and Government: The money from the
government to households flows in an economy in two forms.
First, in the form of transfer payments, such as old age pensions,
scholarships, etc. Second, in the form of factor payments for
hiring factor services of the households. This money flows back
from households to the government in the form of direct taxes,
such as interest tax, income tax, etc.
2. Between Firms and Government: The money from firms to
the government flows in an economy in the form of direct and
indirect taxes. However, the money from the government to the
firms flows into an economy in the form of subsidies. In this
case, the government grants subsidies to the firms and makes
 payments to the firms for the purchase of goods and services
produced by them. The financial market also plays an important
role in a three-sector economy, as the government saves a part of
their earned income and deposits the same in the financial
market. Besides, the government also borrows money from the
financial market so it can meet its expenditures.

Gross Domestic Product(GDP):

Meaning of GDP (Gross Domestic Product)

Gross Domestic Product (GDP) is the total monetary value of all final
goods and services produced within a country's borders in a specific
time period, usually a year or a quarter. It is a key indicator used to
measure a country's economic performance and overall economic
health.

Concept of GDP
The concept of GDP revolves around measuring the economic activity
within a country. It includes:
1. Production Approach– Calculates GDP by summing the value of all
goods and services produced.
2. Income Approach – Adds up all incomes earned by individuals and
businesses, including wages, profits, and taxes.
3. Expenditure Approach– Measures GDP by adding up total
spending on consumption, investment, government expenditures, and
net exports (exports - imports).

GDP helps in comparing economic performance across different

countries and over time. It also serves as a guide for policymakers to
make economic decisions.

Definitions of GDP :

1. According to the World Bank:

"GDP is the sum of the gross value added by all resident producers
in the economy plus any product taxes and minus any subsidies not
included in the value of the products."

2. According to Paul Samuelson and William Nordhaus:

"GDP is the market value of all final goods and services produced
within a country in a given period."

3. According to IMF (International Monetary Fund):

"GDP measures the monetary value of final goods and services—
that is, those that are bought by the final user—produced in a country
in a given period."

GDP is widely used to assess economic growth, living standards, and

the overall development of a country. However, it does not account
for income distribution, environmental factors, or informal economic
activities.

Meaning of GNP (Gross National Product):

Gross National Product (GNP) is the total monetary value of all final
goods and services produced by a country’s residents, both within and
outside its borders, in a specific time period, usually a year or a
quarter. Unlike GDP, which considers only domestic production, GNP
includes income earned by nationals from foreign investments and
subtracts income earned by foreigners within the country.

Concept of GNP:

The concept of GNP is based on nationality rather than location. It

includes:

Income Earned Abroad – GNP considers the earnings of a country’s

residents from overseas investments, businesses, and employment.
Exclusion of Foreign Earnings – It excludes income generated by
foreign individuals and businesses operating within the country’s
borders.
Measurement Approaches – Similar to GDP, GNP can be calculated
using the Production Approach, Income Approach, or Expenditure
Approach.

Relationship with GDP:

GNP=GDP+ Net Factor Income from Abroad (NFIA)

Where NFIA = Income earned by nationals abroad – Income earned
by foreigners domestically.
GNP is useful for assessing the total income earned by a nation's
citizens, regardless of where they are located.
Definitions of GNP:

According to the World Bank:

"Gross National Product (GNP) is the sum of GDP and net income
from abroad, including wages, salaries, and property income."

According to Paul Samuelson and William Nordhaus:

"GNP is the total market value of all final goods and services
produced by the residents of a country in a given period, regardless of
location."

According to the International Monetary Fund (IMF):

"GNP measures the economic output produced by the nationals of a
country, including those living abroad, while excluding the production
by foreign nationals within the country."

Net National Product(NNP):

Meaning of NNP (Net National Product)

Net National Product (NNP) is the total monetary value of all final
goods and services produced by a country's residents (both
domestically and internationally) in a specific time period, after
accounting for depreciation (wear and tear of capital assets). It
represents the actual productive capacity of a nation.

Concept of NNP

NNP is derived from Gross National Product (GNP) by subtracting

depreciation (Capital Consumption Allowance - CCA). It indicates
how much a nation can consume without depleting its capital stock.
The formula is:

NNP=GNP−Depreciation
Where:
GNP (Gross National Product) = Total output by a country’s
nationals, including income from abroad.
Depreciation = Loss of value of capital goods due to wear and tear,
obsolescence, or usage over time.

NNP helps in determining the sustainable level of economic

production and is considered a more accurate measure of a nation's
economic well-being than GNP.

Definitions of NNP:

According to Paul Samuelson and William Nordhaus:

"NNP is the net market value of all final goods and services produced
by a nation's residents after deducting depreciation."

According to the World Bank:

"Net National Product (NNP) is the Gross National Product (GNP)
minus depreciation of capital goods."

According to the International Monetary Fund (IMF):

"NNP measures the total output produced by nationals, adjusted for
capital depreciation, providing a clearer picture of long-term
economic sustainability."

Meaning of Personal Income

Personal income refers to the total earnings received by individuals or
households from various sources, including wages, salaries,
investments, and transfer payments, before taxes.

Concept of Personal Income

It represents the total income available to individuals for spending,

saving, or paying taxes. It includes all sources of earnings, whether
from employment, business, property, or government benefits.

Meaning of Disposable Income

Disposable income refers to the amount of money an individual or
household has left after deducting taxes from personal income. It
represents the actual earnings available for spending and saving.

Concept of Disposable Income

It is the portion of personal income that can be used for consumption,
savings, or investments. It plays a key role in determining an
individual's standard of living and economic well-being.

Meaning of Per Capita Income (PCI)

Per capita income refers to the average income earned per person in a
specific area (such as a country or region) during a given period,
usually a year. It is calculated by dividing the total income of a nation
or region by its total population.

Concept of Per Capita Income

It is a key economic indicator used to measure the standard of living
and economic well-being of a population. A higher per capita income
generally indicates better economic conditions and prosperity.