Macro Economics

Unit 2

Compiled by
Dr. Ashi Stuart
 Circular Flow of Income

The circular flow of income is an economic Households are consumers of goods and
model that reflects how income flows services and the owners of the factors of
through the different sectors of the production (land labour, capital, and
economy. A simple economy assumes that enterprise). However, the firm sector
there exist only two sectors, i.e., produces goods and services and sells them
Households and Firms. to households.

Households provide the firms with the

factors of production namely, Land
(Natural Resources), Labour, Capital,
and Enterprise that generates goods and
In the circular flow of income (two-sector
services, and consumers spend their income
economy), there is an exchange of goods
on the consumption of these goods and
and services between the two players, i.e.,
services. The firms then make factor
the firms and households, which leads to a
payments to households in the form of rent,
certain flow of money in the economy.
wages, interest, and profit. This flow of
goods and services and factors payments
between firms and households reflects the
circular flow of money in an economy.
Types of Circular
Flow
• Real Flow- The flow of factor services from the households to the
firms and the corresponding flow of goods from firms to the
households in an economy is known as the Real Flow. In this type of
circular flow, there is no involvement of money and the goods and
services are exchanged between the two sectors of the economy.

• Money Flow- The flow of factor payments from the firms to

households for their factor services and the corresponding flow of
consumption expenditure from households to the firms for the
purchase of goods and services produced by the firms is known as
Money Flow. This type of circular flow includes the exchange of
money between the two sectors, i.e., households and firms.
 Gross Investment, Net Investment and Depreciation
• Gross Investment- Gross Investment is referred to the total expenditure
or investment that is made by an organization to acquire capital goods
(which includes unsold stock and fixed assets). It is the gross value for
such expenditure and it doesn’t take the factor of depreciation into
consideration.
• Net Investment- Net investment is the actual addition made by the
organizations to the economy’s capital stock in a given period. In other
words, it is determined by subtracting depreciation from the gross
investment of an economy.
Net Investment = Gross Investment – Depreciation
• Depreciation- A reduction in the monetary value of fixed assets due to
wear and tear caused by continuous use or any other reason is known as
Depreciation. Capital goods that a business does not consume within a
year of production cannot be completely deducted, as business expenses
in the year of their purchase, rather, they must be depreciated over the
period of their valuable lives, with the business taking partial tax
deductions divided among the years that the capital goods are in use.
This is done through techniques of accounting, such as depreciation or
devaluation.
 Net Indirect Taxes, Factor Cost, Market Prices
• Net Indirect Tax (NIT) refers to the difference between
indirect taxes and subsidies. Indirect Taxes are the taxes
imposed on the production and sale of goods and services by
the Government of a country, for example, GST (Goods and
Services Tax). Subsidies are the economic assistance given to
firms and households by the government with the aim of the
general welfare. It is also known as financial assistance.
Net Indirect Tax = Indirect Taxes – Subsidies
• Factor Cost Vs Market Price- Factor cost is the amount paid
to the factors of production for the factor services provided by
them in the production process. However, Market Price is the
price at which the product is actually sold in the market to the
consumers. The Market Price of a good or service includes
indirect taxes and excludes subsidies.
Market Price = Factor Cost + Net Indirect Taxes
 Net Factor Income from Abroad (NFIA)
• Factor income from abroad is the income earned by a country’s normal residents from the
rest of the world for the factor services provided by them. The income is earned in the
form of rent, wages, interest, salaries, dividends and retained earnings. However, Factor
income to abroad is the income paid by a country’s normal residents to the normal
residents of other countries (i.e., non-residents of the former country) for the factor
services given by them within the economic territory.
Net Factor Income from Abroad = Factor income earned from abroad – Factor income
paid abroad
• Significance of Net Factor Income from Abroad (NFIA)
• Net Factor from Abroad (NFIA) is essential for differentiating between the Domestic
Income and National Income of an economy. At first, the Domestic Income is determined,
and then after adding NFIA to it, National Income is determined.

National Income = Domestic Income +Net Factor Income from Abroad

 What is Value Added?
• Value-added refers to the addition in the value of a raw material or intermediate good by an organization
during the production process. To calculate the national income through the value-added method, the
difference between the value of output and the value of intermediate goods is taken. The value-added method
is the most commonly used method to estimate national income as it avoids double counting, which is a major
error while calculating national income.
• For example, A baker needs only flour to produce the goods. He purchases the flour from a miller as an
intermediate good worth ₹30 and converts the flour into bread with the help of production activities, and sells
the bread for ₹50. Here, flour is an Intermediate Good whose value is ₹30 and is termed the value of
Intermediate Consumption.
• Bread sold to the baker is the final good whose value is ₹50 and is termed Value of Output. It shows that the
baker has added a value of ₹20 to the flow of final goods & services in the economy.
• As discussed above, the difference between the value of output and the value of intermediate goods is known
as value added.
Value Added = Value of Output – Intermediate Consumption
= 50 – 30
= ₹ 20
 National Income and Related Aggregates
• National Income is the aggregate value of all goods and services produced
by firms in a given financial year. It can be stated that when the aggregate
revenue generated by the firms is paid out to factors of production, it equals
aggregate income or National Income. There are different variants or
aggregates of National Income and each of the aggregates has a specific
meaning, use, and method of measurement. These aggregates are as follows:
1.Gross Domestic Product at Market Price (GDPMP)
2.Gross Domestic Product at Factor Cost (GDPFC)
3.Net Domestic Product at Market Price (NDPMP)
4.Net Domestic Product at Factor Cost (NDPFC)
5.Gross National Product at Market Price (GNPMP)
6.Gross National Product at Factor Cost (GNPFC)
7.Net National Product at Market Price (NNPMP)
8.Net National Product at Factor Cost (NNPFC)
 GDPMP
1. Gross Domestic Product at Market Price (GDPMP)
• GDPMP refers to the gross market value of all the final goods and services
produced during a year within the domestic territory of a country.
• Gross in GDPMP means that the total value of final goods and services
includes depreciation, i.e., no provision has been made for it.
• Domestic in GDPMP means that the final goods and services produced are
located within the domestic boundaries of the country.
• Product in GDPMP indicates that only final goods and services are
included.
• Market Price in GDPMP means that the amount of indirect taxes paid is
included in GDP; however, the subsidies are excluded from it.
 GDPFC, NDPMP, NDPFC
2. Gross Domestic Product at Factor Cost (GDPFC)
• GDPFC refers to the gross money value of all the final goods and services produced
during a year within the domestic territory of a country. It can be determined as:
GDPFC = GDPMP – Net Indirect Taxes
3. Net Domestic Product at Market Price (NDPMP)
• NDPMP refers to the net market value of all the final goods and services produced during
a year within the domestic territory of a country. It can be determined as:
NDPMP = GDPMP – Depreciation
4. Net Domestic Product at Factor Cost (NDPFC)
• NDPFC refers to the net money value of all the final goods and services produced during a
year within the domestic territory of a country. It can be determined as:
NDPFC = GDPMP – Net Indirect Taxes – Depreciation
• NDPFC is also known as Domestic Factor Income or Domestic Income.
 GNPMP, GNPFC
• 5. Gross National Product at Market Price (GNPMP)
• GNPMP refers to the gross market value of all the final goods and services
produced during a year by the normal residents of a country. It can be
determined as:
GNPMP = GDPMP + Net Factor Income from Abroad
• GNPMP of a country can be less than its GDPMP if NFIA is negative.
However, it can be more than GDPMP if NFIA is positive.
• 6. Gross National Product at Factor Cost (GNPFC)
• GNPFC refers to the gross money value of all the final goods and services
produced during a year by the normal residents of a country. It can be
determined as:
GNPFC = GNPMP – Net Indirect Taxes
 NNPMP, NNPMP
• 7. Net National Product at Market Price (NNPMP)
• NNPMP refers to the net market value of all the final goods and services
produced during a year by the normal residents of a country. It can be
determined as:
NNPMP = GNPMP – Depreciation
• 8. Net National Product at Factor Cost (NNPFC)
• NNPFC refers to the net money value of all the final goods and services
produced during a year by the normal residents of a country. It can be
determined as:
NNPFC = GNPMP – Net Indirect Taxes – Depreciation
• NNPFC is also known as National Income.
Domestic Income (NDPFC) v/s National Income (NNPFC)
 National Income
• National income is the total value of goods and services produced
during a financial year in an economy. In other words, it is the total
amount of money or income accruing to a country from different
economic activities during a financial year. National Income is the
most comprehensive measure of an economy’s performance and can
be calculated by three different methods:
1.Value added method or Product method
2.Income method
3.Expenditure method
Value Added
Method/
Product
Method
Income Method
Expenditure
Method