NATIONAL INCOME & CIRCULAR FLOW OF CASH

Definition: The income earned by a country's people, including labor and capital investment.

It measures the total value of the goods and services(output) produced by an economy over a period

of time (normally a year).It is also a measure of the income flown from production, and/or the sum

total of all spending involved for the production of output.

The study of National Income is important because of the following reasons:

1. To measure the size of the economy and level of country’s economic performance

2. To trace the trend or speed of the economic growth in relation to previous year(s) as well as to

other countries

3. To know the structure and composition of the national income in terms of various sectors and the

periodical variations in them

4. To make projection about the future development trend of the economy.

5. To measure the size of the economy and level of country’s economic performance

6. To trace the trend or speed of the economic growth in relation to previous year(s) as well as to

other countries

7. To know the structure and composition of the national income in terms of various sectors and the

periodical variations in them

8. To make projection about the future development trend of the economy

Internationally some countries are wealthy, some countries are not wealthy and some countries are in-

between. Under such circumstances, it would be difficult to evaluate the performance of an economy.

Performance of an economy is directly proportionate to the amount of goods and services produced in an

economy. Measuring national income is also important to chalk out the future course of the economy. It

also broadly indicates people’s standard of living.

National Income Accounting represents the tools and methods by which economists and policy-makers

measure economic activity and economic growth over time. It measures the total value of the goods and

services(output) produced by an economy over a period of time (normally a year).It is also a measure of

the income flown from production, and/or the sum total of all spending involved for the production of

output.

Income can be measured by Gross National Product (GNP), Gross Domestic Product (GDP), Gross

National Income (GNI), Net National Product (NNP) and Net National Income (NNI).

In India the Central Statistical Organization has been formulating national income.

However some economists have felt that GNP has a measure of national income has limitation, since they

exclude poverty, literacy, public health, gender equity and other measures of human prosperity. Instead

they formulated other measures of welfare like Human Development Index (HDI)

Calculating National Income

There are various methods for calculating the national income such as production method, income

method, expenditure method etc.

Production Method

The production method gives us national income or national product based on the final value of the

produce and the origin of the produce in terms of the industry.

All producing units are classified sector wise.

Primary sector is divided into agriculture, fisheries, animal husbandry.

Secondary sector consists of manufacturing.

Tertiary sector is divided into trade, transport, communication, banking, insurance etc.

Calculation of National Income of India: A Brief History

The first attempt to calculate National Income of India was made by Dadabhai Naroji in 1867 -68. This

was followed by several other methods. The first scientific method was made by Prof. V.K.R Rao in

1931-32. But this was not very satisfactory. The first official attempt was made by Prof.P.C.Mahalnobis

in 1948-49, who submitted his report in 1954.

Methods of calculating National Income

There are three approaches to the measurement of national income:

Income Method

Spending or Expenditure Method

Production or Output Method

Income = Expenditure = Output

Y = E = O

Spending or Expenditure Approach

The spending approach divides GDP into four areas:

• Households (Consumption expenditures) (C)

• Businesses (Domestic Investment) (I)

• Government (Govt. expenditures) (G) and

• Foreigners (Export (X) and Imports (IM)of Goods and Services) (X-IM).

GDP = E = C + I + G + (X–IM)

Income Method:

Different factors of production are paid for their productive services rendered to an organization. The

various incomes that includes in these methods are wages, income of self employed, interest, profit,

dividend, rents, and surplus of public sector and net flow of income from abroad.

• The measure of GDP are calculated by adding all the income earned by various factors of

production which are engaged in the production of output.

• In addition to aggregate income, national income and personal income are also used as measures

of income.

It includes…

– Wages and salaries

– Farm income

– Rent

– Sales taxes

– Depreciation (the amount of capital that has worn out during the year)

Expenditure Method:

The various sectors – the household sector, the government sector, the business sector, either spend their

income on consumer goods and services or they save a part of their income. These can be categorized as

private consumption expenditure, private investment, public consumption, public investment etc.

• The measures of GDP are Calculated by adding the total value of the output (of goods and

Service) produced by all activities during any time period, such as a year.

• The production approach looks at GDP from the standpoint of value added by each input in the

production process.

• major challenge – problem of double counting

Output of many business = input of some other

Difficulties in Calculation of National Income

In India there are various difficulties in calculating the national incomes .The most severe one is the

finding of reliable data. Most of the time, it is based on assumptions. Soon after independence the

National Income Committee was formed to collect data and estimate National Income. The two major

problems which remain in the calculation of National Income are:

Most of the data is not from the current year.

Even if current data are available then values are underreported.

Obstacles in High Growth of National Income of India

Even if the Indian economy grows faster than the BRIC countries and G 6, the benefits of the growth

would not be evenly distributed. India’s progress in education cannot be termed as satisfactory. In terms

of higher education it has achieved tremendous success, but its unsatisfactory performance in primary

education and secondary education has been a major obstacle to growth. Similarly India’s healthcare

system is in a less than desirable state. Governments’ spending on public health has not been up to the

required levels.

GROSS DOMESTIC PRODUCT

The Indian economy is the 12th largest in the world

It ranks 5th pertaining to purchasing power parity (PPP) according to the latest calculation of the

World Bank

The GDP of India in the year 2007 was US $1.09 trillion

India is the one of the most rapidly growing economies in the world

The growth rate of the India GDP was 9.4% per year

Due to the huge population the per capita income in India is $964 at nominal and $4,182 at PPP.

Calculation Overview

Simple Economy…..No Govt…no foreign trade

C=consumption I=investment S=saving Y= Income

Output produced=output sold i.e, Y = C + I ………….(1)

Introducing Govt. in the above identity

G = Govt. purchases of goods and services

TA = all taxes

TR = transfers to private sector (including interest)

NX = net exports (exports-imports)

YD = disposable income

Y = C + I + G + NX……….(2)

YD = Y + TR – TA ………..(3)

YD = C + S …..……………(4)

C = YD – S = Y + TR – TA – S……………..(5)

Consumption is disposable income less saving

Or consumption is equal to income plus transfers less taxes and saving

Using RHS of (5) in (2) :

Y = (Y + TR – TA – S) + I + G + NX

S – I = (TR – TA + G) + NX …………(6)

Govt. budget deficit,

i.e., Excess of private saving over investment = total govt. expenditure consisting of govt. purchases of

goods and services(G) + Govt. transfer payments (TR) + net exports – amount of taxes (TA) received

by govt.

Problems in calculating National Income

• Black Money : It has created a parallel economy - unreported economy which is equivalent to

the size of officially estimated size of the economy

• Non-Monetization : In most of the rural economy, considerable portion of transactions occurs

informally

• Growing Service Sector : growing faster than Agricultural and Industrial sectors… value

addition in legal consultancy, health service ,financial and business services is not based on

accurate reporting.

• House Hold Services : It ignores domestic work and house keeping services

• Social Services : It ignores volunteer and unpaid social services. (Mother Teresa’s social service)

• Environment Cost : It does not distinguish between environmental-friendly and environmental-

hazardous industries … cost of polluting industries is not included in the estimate.

National Income series in India

• National Accounting system was initiated in the mid-sixties

• Indian System of National Accounting statistics follows the UN system of national accounts

(1968)

• Based on the National Income Committee’s recommendation(1954), the Central Statistical

Organization(CSO) has been estimating the NI

• The CSO revised its national accounting series by shifting the base year to 1970-71 … again to

1980 – 81 and then to 1993-94.. recently by improving the database and extended coverage the

base year shifted to 1999-2000

Growth of National Income in India

The Circular Flow of Income

2010f

Product Market The market for consumer goods and services.Factor Market The market for the factors of production. (land, labour, capital, and

enterprise)

Household Sector Made up of clusters of individuals.Business Sector Made up of businesses of various types and sizes, from small family-run

proprietorships to large corporations.The four factors of production are combined to produce the goods and services that individuals consume on a daily basis.In our private enterprise or pure market economy, the factors of production are, ultimately, owned by individuals.

Individuals control the sale of their own labour; Individuals own land and mineral rights; and Individuals own the shares of a corporation’s assets or (for our purposes) capital.

The factors of production therefore, flow from the household sector, through the factor market, to the business sector.

The business sector must pay for the factors they receive. This payment flows from the business sector into the household sector, and becomes income. Incomes take a variety of forms:

Supply of Factors of Production(Land, Labour, Capital & Organization)

Payment for CommoditiesSupply of Commodities

Payment for Factor Services(Rent, Wages, Interest and Profit)

(Goods & Services)

(Commodity Price)

Firms /

Producers

Households

/ Consumers

Public Businessmon

ey f

low

rea

l flo

w

Circular Flow of Income

Rent (r): the payment made and the income received for the use of land. (i.e. the payment for the use of a natural resource, and not simply the payment for the use of an apartment or other building.)

Wages (w): the payment made and the income received for the use of labour. (includes commissions, tips, and all employee benefits.)

Interest (i): the payment made and the income received for the use of capital.

Profits (): the income received from the activity of enterprise. (The income which is left over after all the factors of production have been paid. Profits can be thought of as a reward for enterprise.)

Businesses use the factors of production to produce consumer goods and services. These goods and services flow from the business sector, through the product market, to the household sector.

Households use the income received from the sale of factors to pay for these consumer goods and services. In other words, they engage in consumption.

Consumption: the expenditure by households on goods and services.

Ref. Websites

Government of India, Ministry of Statistics

http://mospi.gov.in/ or http://www.mospi.nic.in/

Central Intelligence Agency (CIA)

https://www.cia.gov/library/publications/the-world-factbook/geos/in.html

Wikipedia

http://en.wikipedia.org/wiki/Gross_domestic_product

India In Business

http://www.indiainbusiness.nic.in