Circular Flow of Income & Methods of Calculating National Income

Both inflow and expenditure are integral parts of any functional economy. They tend to come in handy for analysing the performance of an economy and further helps to formulate effective strategies for different economic sectors. It must also be noted that the circular flow of money creates a link between consumers and producers and helps create functional market networks.

On that note, let’s find out more about the circular flow of income in an economy from below. 

What is Circular Flow of Income?

The circular flow of income can be explained as a functional economic model which represents how money flows through the different sectors in an economy. It depicts how produced goods and services, income and expenditure tend to flow in an economy. One can explain the circular flow of income and expenditure with three types of economy, namely – two-sector economy, three-sector economy and four-sector economy. 

Typically, there are 3 phases of the circular flow of income in a simple economy or closed economy –

  1. Production Phase: It is primarily concerned with income generation.

  2. Income Phase: It includes movement of factor income like rent, wage, interest and profits from production firms to household.

  3. Expenditure Phase: In this phase, the income generated through factors of production is spent mostly on goods and services which are produced by firms.

Notably, there are several factors of production and consumption like, labour, capital, enterprise, rent, wage, interest and profit, which tend to affect the circular flow of money. Also, there are different types of the circular flow of economic activity one should become aware of. 

Types of Circular Flow of Income 

Generally, they are of 4 types  –

  1. Real Flow: It indicates the movement of factor services from households in an economy to its business units. It also shows the movement of goods and services from business units to households of an economy.

  2. Money Flow: It indicates the movement of money from different economic sectors in terms of factor payments for availing factor services. 

  3. Injections: In practice, money is introduced into an economy for firms and household borrowing from financial institutions. 

  4. Leakages: Typically, indicates the withdrawal of money from the flow.

On that note, let’s take a close look at how money flows in a two-sector economy.

Circular Flow of Income: In a Two-Sector Economy

Notably, it is a hypothetical concept, where the economy comprises only two sectors, namely, households and business firms. In such a setup, the households serve as a source of factors, and they generate income by providing factor services to business firms. On the other hand, business firms serve as a provider of goods and services generate income by supplying the same to households within the economy. 

In simple words, the circular flow of income in a two-sector economy can be defined as the flow of money and receipt of goods, service and factor services between business firms and households sectors.

Take a look at this diagram below to understand the functioning circular flow of income in a two-sector economy effectively.

Here, the outer flow indicates the monetary flow, while the inner flow indicates the real flow of income. In turn, it indicates that the expenses incurred by the household sector emerge as an income source for the business firms and vice versa. Hence, it can be said that,

Money received by producers = Household earnings = Households’ expenses on consumptions.

However, such a model is based on some assumptions to make it more practical. Such assumptions which as follow –

  1. There are 2 sectors in the economy, i.e. business firms and households.

  2. The economic activities are free from government intervention.

  3. It is a closed economy, where business firms do not participate in import and export.

Test Your Knowledge: Can you name all the sectors in the circular flow of income in four sector economy?

What are the Methods of Calculating National Income?

There are 3 methods to compute national income –

  1. Income Method

In case of income method of calculating national income, the primary emphasis is on production factors such as land, labour, capital and enterprise. It also factors in income through rent, salaries, interest, wages and profits. Notably, it excludes transfer payment, lottery, profit tax and sale of second hand goods. 

Formula of income method of national income = Rent + Wages + Interest + Profit + Mixed Income.

  1. Expenditure Method

In this expenditure method of calculating national income, the main focus is on expenses of residents, business firms or the government. It is inclusive of these following –

  1. Goods and services purchased by households (C)

  2. Expenses of business firms (I)

  3. Government expenses (G)

  4. Net exports (NX)

Expenditure method of national income formula = C + G + I + NX

  1. Value Added Method

In this method, the main emphasis is laid upon value-added to any given product at each production stage. One needs to factor in the value of all goods and services produced by all firms in every industry in the economy.

Value-added method formula = (NDPFC) + Net factor income from abroad

It must be noted that here, NDPFC is the net domestic income of an economy.

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FAQ (Frequently Asked Questions)

1. What Is Circular Flow of Income?

It can be described as the flow of products, services, income and expenses in an economy. Typically, there are 3 phases inflow of income – Production phase, income phase and expenditure phase.

2. How Is National Income Calculated?

National income can be calculated by using these three methods – Income method, expenditure method or value-added method.

3. What Is The Formula of Income Method of National Income?

The formula of income method is Rent + Wages + Interest + Profit + Mixed-Income

4. What Is The Expenditure Method Formula?

The expenditure method formula is C + G + I + NX (Consumer + Government expenses + Expense of business firm + Net export)