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Introduction of National Income | Circular Flow of Income and Expenditure in the 2 Sector Economy

INTRODUCTION OF NATIONAL INCOME | CIRCULAR FLOW OF INCOME AND EXPENDITURE


INTRODUCTION OF NATIONAL INCOME

National income is the single most important macroeconomic variable that represents the economy as a whole. It determines other macroeconomic variables such as total consumption, total saving, total investment, price level, employment level, etc. Therefore, a systematic and reliable calculation of national income is necessary for the study of the economy as a whole. It is important for both theoretical and practical points of view. At the theoretical level, it explains the determination of national income, the relationship between its components, economic growth, and its function. 

Similarly, from the practical point of view, it is very useful for measuring living standards and economic welfare of people, formulation of economic policies, and making an international comparison about the status of the economy. In this chapter, we will begin a study of national income with a circular flow of income and expenditure. Thereafter, we will study various concepts of national income, measurement of national income, problems or difficulties in the measurement of national income, and importance of national income. Besides, various numerical examples will be given to make clear with different methods of the calculation of national.



CIRCULAR FLOW OF INCOME AND EXPENDITURE

The economy is an integrated activity for production, distribution, and consumption. In carrying out these economic activities, people are involved in making transactions, i.e. buying and selling of goods and services. Economic transactions generate two kinds of flows: flows of goods and services and flow of money. Product and money flow in the opposite direction. For example, when people buy goods and services, they have to pay what is received by the seller. Similarly, when producers or firms buy or hire factors of production, they have to make payment which is received by the factory owner.

The circular flow of income and expenditure is the integrated flow of resources and goods and services among the different sectors of the economy. This concept is actually abstract and complex in reality. But here it is studied simplified models to illustrate the circular flow of income and expenditure. To illustrate the circular flow of income and expenditure, the economy is divided into four sectors: household sector, business sector, government sector, and foreign sector, and all these sectors are combined together to explain the circular flow of income and expenditure. In order to explain the circular flow of income and expenditure, we make the following three models:

1. Circular flow of income and expenditure in the two-sector economy.
2. Circular flow of incomes and expenditure in the three-sector economy.
3. Circular flow of incomes and expenditure in the four sector economy

The circular flow of income and expenditure of these three models has been explained as follows:



1. IN THE TWO-SECTOR ECONOMY

The two-sector economy consists of only the household and business sectors. This is the most simplified economic model in which product and money flow generated by the government and the foreign sector are ignored. This is obviously an unrealistic model. In other words, such kind of economy is not found in the real world. This is also known as a two-sector closed economy.


Assumptions

The circular flow of income and expenditure in the two-sector economy is based on the following assumptions:

  • There are only two sectors in the economy: household and business sectors.
  • All income is spent on consumption. There is no saving in the economy.
  • There is no government and no international trade.
  • Households are owners of factors of production or factors of production are supplied only by households.
  • Producers purchase or hire factors of production from the households.

On the basis of these assumptions, we can present circular flow of income and expenditure as follows:


INTRODUCTION OF NATIONAL INCOME | CIRCULAR FLOW OF INCOME AND EXPENDITURE


The figure shows the circular flow of income and expenditure in the two-sector economy. The upper half of the figure represents the factor market and the lower half of the figure represents the commodity market. Both these markets generate two kinds of flows: real or product flow and money flow.

In the upper half of the figure, there is the flow of factors of production from the household sector to the business sector. This makes real flow. And the real flow or factor flow causes another flow, and a reverse flow, that is the flow of factor incomes in the form of wages, rent, profit, and interest from firms to the households. Since all factor incomes are paid in the form of money, the flow of factor income represents money flow. From the figure, it is clear that factor services and money flow in the opposite direction.

The lower half of the figure shows the commodity market. As in the figure, the goods and services produced by the business sector or business firms flow from the business sector or business firms to households. The payment made by the households for goods and services creates money flow. It is clear that real (goods) and money flows in the commodity market also flow in the opposite direction.

When we combine the goods and money flow in the goods and money market, we will get the continuous circular flow of income and expenditure. It is also clear that income flow and money flow are equal.



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