Circular Flow of Income and National Income Calculation Methods

The circular flow of income is about how money gets paid around in the economy. There are two main types of actors in this flow. There are businesses, which produce goods and services, employ people to work for them, pay wages on their behalf and charge customers for the things they sell. There are the households, which consume goods and services, employ people to work for them, provide wages to those people from their incomes and who have money left over from their budgets after they have bought what they need. We will be looking at how these flows go around in a simple circular flow diagram later on in this article.

The calculation of national income is a measure of the total amount of economic activity in a country over some time. It takes into account all the money that has been earned by selling things and all the money that has been paid out for wages, rent, interest and so on. It can be used to see how well the economy is performing and how it is changing. The calculation of national income is usually broken down into three steps. These are the so-called 'identifiable expenditure approach' which looks at how households use their money, the 'expenditure method' which considers how businesses use their incomes and finally there is the 'income method'. We will look at each of these in turn.

Identifiable Expenditure Approach

This first step considers how households spend their money. A large part of household spending is on things that are made by businesses, for example, houses, cars and furniture. These are the 'identifiable expenditure items'. Some of these goods are called 'final' because they are finished products that aren't used again to make anything else. For example, when you buy a car, it is finished and can't be used to produce any other goods.

Another household spending is on things that are called 'intermediate' because they are used to produce other things. For example, when you buy coal, it is an intermediate good because it is used to produce electricity. The calculation of national income takes into account only final goods. It does this by looking at how much money is spent on each type of good.

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 help 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 households.

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 households 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 that 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, services and factor services between business firms and households.

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 a four sector economy?

What are the Methods of Calculating National Income?

There are 3 methods to compute national income –

1. Income Method

In the case of the 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.

2. Expenditure Method

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

3. 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.

Are you interested in learning about the importance of the circular flow of income as well? Get enrolled at Vedantu’s free live online classes and learn more about it from the subject experts’ right from the comfort of your home. You can also access our compact PDF study solutions to strengthen your grasp on the circular flow of income in the three sector economy and much more. 

Conclusion

In a nutshell, the circular flow of income diagram represents the flow of money and receipt of goods, services and factor services between business firms and households sectors in a two-sector economy. Notably, the economic activities are free from government intervention and it is a closed economy model.