Circular Flow of Income and Methods of Calculating National Income – Class 12 Economics
Circular Flow of Income – Through the circular flow of income, we will learn how the simple economy functions without government, trading, and saving.
Household receive payments in the form of-
- Wage- Remuneration for the contribution made by human labor.
- Interest- Remuneration for the contribution made by capital.
- Profit- Remuneration for the contribution made by entrepreneurship.
- Rent– Remuneration for the contribution made by fixed natural resources like land.
It is assumed that the household does not save any earning or pay any tax to the government or buy any imported goods. Household disposes of all their earnings by buying goods and services produced by the domestic firm. In economic terms, aggregate consumption by the household in the economy is equal to aggregate expenditure incurred by the firm on producing goods and services in the economy.
Again, the firm will produce goods and services and distribute factor of payments. The remuneration received as the factor of payments will be used to buy goods and services. This cycle is repeated again and again. We can conclude that aggregate income of economy passes through two sectors household and firm in a circular form as we can see in the diagram given below.
When a household buys goods and services from the firm, it becomes aggregate expenditure received by the firm. Where aggregate expenditure is equal to aggregate income. When this aggregate revenue is paid by the firm in the form of the factor of payments, it forms aggregate income.
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Goods and service market
The first arrow on the top represents – household spending to buy goods and services. It shows the flow of payments.
The second arrow on the top represents – the flow of goods and services to the household.
Factors of the production market
The first arrow on the bottom represents – factor payments for the services provided by the firm.
The second arrow on the bottom represents- services household rendering to the firm.
Methods of calculating national income
- Product or value-added method
In this method, national income is calculated on the basis of value added to the product at different stages of production.
To calculate national income, the value of goods and services produced by the firm across all industries are added up together.
Points to be considered
- The economy is divided on the basis of industries.
- The units of outputs are considered in monetary terms.
- The gross domestic product at market price is considered.
- All the indirect taxes are subtracted and subsidies are added (Gross domestic product at factor cost)
- Net value is calculated by deducting depreciation from the total value.
National Income = (NDPFC) + Net factor income from abroad
- Income Method
This method focuses on production factors like land, labour, capital, and income generated in the form of rent, wages, salaries, profits, and interest. This method does not include transfer payments, illegal money, lottery, profit tax and sale of second-hand goods.
National income= Rent + Wages + Interest + Profit + Mixed Income.
- Expenditure Method
This method is based on expenditure like purchase made by residents, government or business enterprises.
- Goods and service purchased by residents or household. (C)
- Government expenditure (G)
- Business enterprise expenditure (I)
- Net exports (NX)
National income = C + G + I + NX
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Tag: Circular flow of income, Methods of Calculating National Income, Class 12 Economics notes, Economics Online Classes,
Product or value-added method, Income Method, Expenditure Method