P2 Circular Flow.pdf MACRO SEM - 2 UNIT 1

Unit 1: Introduction to Macroeconomics
and National Income Accounting
▪ Basic issues studied in macroeconomics;
▪ Measurements of gross domestic product,
income,expenditure, and the circular flow;
▪ real versus nominal GDP;
▪ Price indices;
▪ National incomeaccounting for open economy,
balance of payments accounts, current and
capital accounts.
Time : 10 hours
Readings:
1. Abel, Bernanke and Croushore: Chapter 1 (Sections 1.1
and 1.3), Chapter 2 and 5 (up to Section 5.1 - pp. 165-
176).
2. Instead of Table 5.1 in book use latest Economic Survey
2022-23, Table 5.2 (p. 92-95)

Gross domestic product (GDP)
✓ It is very important to understand what GDP is and how it is measured.
✓ Economists measure total production in an economy by gross domestic product
or GDP.
Gross domestic product (GDP) is defined as the market value of all final goods and
services produced in a country during a period of time.
✓ GDP is measured using market values, not quantities. So, it is measured in
monetary terms.
✓ GDP includes only current production.

Final and intermediate goods
✓ GDP includes only the market value of final goods.
✓ A final good or service is a good or service which is the end product of the
production process that is purchased by a final user.
✓ An intermediate good or service is a good or service that is an input into
another good or service.
✓ For example, the fruits may be consumed directly as the final product or may
be used as an intermediate good in making packaged drinks.

National Income and
Related Aggregates
✓ There are different variants or
aggregates of national Income and
each of the aggregates has a
specific meaning, use, and method
of measurement.
✓ These aggregates are given here.
✓ The National Income (NY) is equal
to NNPFC

Net Domestic Product (NDP)
✓ Net domestic product (NDP) is calculated by measuring GDP and subtracting the
value of depreciation on capital equipment.
✓ Depreciation is the reduction in the value of capital equipment that results from
use or obsolescence.
✓ NDP = GDP – Depreciation

Gross National Product (GNP)
✓ GDP is the market value of final goods and services produced within India.
✓ Gross national product, or GNP, is India’s GDP, plus income generated overseas by
Indian residents and firms, minus the income generated in India by non-residents
and foreign firms.
✓ Indian firms have facilities in foreign countries and foreign firms have facilities in
India.
✓ Tata Motors (an Indian company), for example, has operations overseas and Pepsi
(a US company) has production plants in India.

GNP … contd.
✓ GNP includes foreign production by Indian firms but excludes Indian production
by foreign firms.
✓ GNP = GDP + NFIA
✓ NFIA = Net Factor Income from Abroad
✓ Similarly, the income of Indians working abroad will be included in GNP but not in
GDP.

Thus, in domestic product we are focusing on
the domestic territory.
In national income / product we are focusing on
the income of the residents / citizens.

GDP / National Income of a country
can be measured in 3 different ways
✓ Production / value added method
✓ Expenditure method
✓ Income method

The production method
✓ The sum of the value of all goods and services produced by the sectors in the
economy in a year minus the cost of goods and services used in the productive
process (intermediate goods).
✓ Thus, we sum the value added by the sectors / industries.
✓ This is also called the value-added method
✓ Gross Value Added at Market Price (GVA at MP) = Value of Output – value of
intermediate Consumption
GDP = Sum of GVA in all sectors of the economy
GDP (Factor Cost ) = GDP (Market Price ) - (Indirect Taxes – Subsidies)
GDP (Factor Cost ) = GDP (Market Price ) - (Net Indirect Taxes)

The expenditure method
✓ The expenditure method is the sum of the total expenditure on final goods and
services by households, investors, government and net exports (the expenditure
on exports minus the expenditure on imports).
✓ The expenditures approach categories this spending into five categories:
consumption, investment, government spending, exports, and imports:
Y= C+I+G+(X−M)

The income method
✓ This is the sum of the income generated from the production of goods and services,
which includes profits, wages and other employee payments, income from rent and
interest earned.
✓ The GDP formula or GDP equation is given below:
NDPFC = Compensation of Employees + Rent + Interest + Profit + Mixed-Income of self-
employed
[Operating Surplus = Rent + Interest + Profit]
National Income (NNPFC) = Net Domestic Product at Factor Cost (NNPFC) + NFIA

Measuring GDP using the value-added method
Value added refers to the additional market value a firm adds to a product and is equal to
the difference between the amount the firm sells a good for and the amount it paid other
firms for intermediate goods.

Understanding the circular flow
✓ We have seen that the circular flow diagrams show the real and money flow in
the economy between different sectors.
✓ Therefore, they provide the logic for the income and expenditures of calculation
of GDP.
✓ We see the following illustration of the production method.

Production, expenditure and income and the
circular-flow diagram
✓ When we measure the value of total production in the economy by calculating GDP,
we are simultaneously measuring the value of total income and the value of total
expenditure on goods and services.
✓ This can be demonstrated with the circular flow.

We can use any of these methods to
calculate the GDP.

The circular flow and measurement of GDP
✓ The circular-flow diagram illustrates the flow of transactions in the economy.
✓ Firms sell goods and services to three groups: domestic households, foreign firms
and households, and the government.
✓ To produce goods and services firms use factors of production: labour, capital,
natural resources and entrepreneurship.
✓ Households supply the factors of production to firms in exchange for income in the
form of wages, interest, profit and rent.

The circular flow and measurement of GDP
✓ Firms make payments of wages and interest to households in exchange for hiring
workers and other factors of production.
✓ The sum of wages, interest, rent and profit is total income in the economy. We can
measure GDP as the total income received by households.
✓ The diagram also shows that households use their income to purchase goods and
services, pay taxes and save.
✓ Firms and the government borrow the funds that flow from households into the
financial system.
Thus, we can measure GDP either by calculating the total value of expenditures on final
goods and services or by calculating the value of total income.

Circular-flow diagram for a
2, 3 and 4 sector economy
✓ The circular-flow diagram is used to illustrate the flow of transactions in the
economy.
✓ We show the circular flow in a simplified form.

Two sector
economy:
Firms and
Households

Circular
Income Flow
with Saving
and
Investment

Three Sector
Economy
with
Government

Four Sector Open Economy: Adding Foreign Sector

P2 Circular Flow.pdf MACRO SEM - 2 UNIT 1

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