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ISC Class XII Notes 2024 : Economics (Jamnabai Narsee School (JNS), Mumbai) : Notes

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Prathham Ahuja
Jamnabai Narsee School (JNS), Mumbai

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ECONOMICS CHAPTER 18: NATIONAL INCOME AND CIRCULAR FLOW OF INCOME Class: 12(ISC) 2023-2024 National Income: National Income is defined as the money value of all final goods and services produced by normal residents of a country, whether operating within the domestic territory of the country or outside in a year. Its important aspects are: I. It is a monetary expression. The output of different goods and services is valued at market prices and the values are added together to get national income. Thus, it is the sum of monetary value of all goods and services produced. II. It is the sum of all final goods and services which are sold to final consumers during the year. Intermediate products are to be excluded. III. National income accounts for the current year s output. Any goods and services produced in any previous year and transacted this year as resale should be excluded. IV. Transfer payments or any type of unilateral transfer of money should also be excluded as such payments lead to no contribution. V. National Income is a flow concept which is measured over a period of time. Final products: Final products are those goods and services which are sold to the final users during the year. These goods and services are purchased for final consumers and for investment by producers, and not for resale. All consumer goods and services eg. Food items, refrigerators etc. are final goods. Producer goods which help in the production of other goods in future like machines, buildings etc. Intermediate products Intermediate products are those goods and services which are used by the producers as inputs into a further stage of production also known as non-factor inputs, e.g. seeds, fertilisers purchased by farmers are intermediate products. Double Counting Error Double counting is the error which arises in national income estimation if we add up the total output of all the sectors in the economy, instead of adding up the output of final goods and services only. The problem can be solved by taking the value of final goods and services only. Transfer payments are unilateral payments for which no productive services are rendered in return in the current period. The recipients of these transfer payments do not make any contribution to current production in return for these payments for e.g. old-age pension from government to its employees without any output being produced in the current year. Normal Resident: Normal residents are those persons who ordinarily reside in a country in which they live and whose economic interest lies in that country. It includes nationals as well as foreign nationals. 1 Domestic Territory: It refers to the geographical or political boundary of a country, excluding foreign embassies and international institutions located within the geographical territory, and including the embassies of this country located outside its geographical territory. Domestic Product/ Domestic Income: The money value of final goods and services produced in a year by the production units located within the domestic territory of a country during a particular year. Circular flow of Income: Circular flow of income is defined as the flow of payments and receipts for goods and services and factor services between different sectors of the economy. It includes two-way exchanges. Real flow consists of flow of factors services and goods and services whereas money flow represents flow of money income for factor services such as rent, wages, interest and profit and money expenditure incurred on the purchase of goods and services. Economic sectors of an economy Ideally there are four main economic sectors of any economy: I. Household sector They are the main owners of factors of production like land, labour, capital,entrepreneur. They spend a large part of their income in purchasing goods and services from the producers. They also save a part of their income and at the same time pays taxes to the government out of their income. II. Firms or Business sector It hire services of households and make factor payments to the factors like rent,wages, interest, and profit/loss. They are the main producers of the commodities. III. Government It gets income largely through taxes imposed on the household and business sector in the form of direct and indirect taxes. It buys goods and services from firms and factor services from households. IV. Rest of the world A country exports goods and services to the other countries and similarly it imports goods and services from other countries. Two sector model of circular flow without saving and investment: It is a hypothetical economy where there is no government, and which has no interaction with rest of the world. Real flow consists of flow of factor services from households to firms and flow of goods and services from firms to households. It is represented by solid lines. Money flows comprise flow of factor incomes from firms to households and flow of money expenditure on goods and services from households to firms. It is represented by dashed/dotted lines. 2 As households spend all their income on the purchase of goods and services from the firms, total money receipts of the firms will be equal to total income of the households. Equilibrium circular flow of income: Total production of goods and services by firms Total consumption of goods and services by households. Factor income of the households Factor payments by firms. Income of the firms Expenditure of the households. Two-sector model with saving and investment: We assume that all savings is done by Households only in the two sector model with saving and investment. Real flow consists of flow of factor services from households to firms and flow of goods and services from firms to households. It is represented by solid lines. Money flows comprise flow of factor incomes from firms to households and flow of money expenditure on goods and services from households to firms. It is represented by dashed/dotted lines. Households do not spend all their income on the purchase of goods and services from the firms. They save a part of their income. Savings represent leakage or withdrawal i.e., the amount of money which is withdrawn from the flow of income. 3 However, savings may be used for undertaking investment expenditure on producer goods e.g., plant, machinery etc. Thus, investment expenditure is an injection into the circular flow of income. Injection is the amount of money which is added to the flow of income, which increase the flow of income in an economy. Saving and investments are done through financial institution (capital market) like banks. Equilibrium in the circular flow of income takes place when Injections equal Leakages. Thus, the investment expenditure (I) by the firms is equal to the saving(S) of the household sector. (S = I) Whenever savings exceed investment (S > I), the income flow declines. This represents leakages in an economy, which decreases the level of income. When investment exceed savings (I > S), the income flow increases. This represents an injection in an economy, which pushes up the level of income in an economy. Three sector model of circular flow of income: I. Household II. Firm III. Government It is represented in the diagram below: Real flow consists of flow of factor services from households to firms and flow of goods and services from firms to households. It is represented by solid lines. Money flows comprise flow of factor incomes from firms to households and flow of money expenditure on goods and services from households to firms. It is represented by dashed/dotted lines. 4 Households do not spend all their income on the purchase of goods and services from the firms. They save a part of their income. Savings represent leakage or withdrawal. However, savings may be used for undertaking investment expenditure on producer goods e.g. plant, machinery etc. Thus, investment expenditure is an injection intothe circular flow of income. Saving and investments are done through financial institution (capital market) like banks. The government charges taxes from the individuals in the form of income tax, wealth tax, sales tax etc. and from the firms in the form of corporate tax. This increases the income flow from the household and firms to the government. Government spending is in the form subsidies, factor payments and transfer payments. Tax form leakage from the circular flow but government expenditure constitutes injections into the circular flow. It is shown by dotted lines in the diagram. Equilibrium in the circular flow of income takes place when Leakages equals Injections. The equilibrium condition of circular flow of income in three sector model is: S + T = I + G. This equilibrium condition implies that saving plus taxes taken together must be equal to investment and government expenditure taken together. However, if (S +T) exceed (I + G), income flow decreases, which reduces the level of economic activities in an economy. If (I + G) exceed (S +T), income flow increases, which increases the level of economic activities in an economy. 5 Four-sector model of circular flow of income. A four-sector model is reflection of an open economy. A four-sector model shows real and money flows between following sectors: I. II. III. IV. Households Firms Government Rest of the world It is represented in the diagram below: Real flow consists of flow of factor services from households to firms and flow of goods and services from firms to households. It is represented by solid lines. Money flows comprise flow of factor incomes from firms to households and flow of money expenditure on goods and services from households to firms. It is represented by dashed/dotted lines. Households do not spend all their income on the purchase of goods and services from the firms. They save a part of their income. Savings represent leakage or withdrawal. However, savings may be used for undertaking investment expenditure on producer goods e.g. plant, machinery etc. Thus, investment expenditure is an injection intothe circular flow of income. Saving and investments are done through financial institution (capital market) like banks. The government charges taxes from the individuals in the form of income tax, wealth tax, sales tax etc. and from the firms in the form of corporate tax. This increases the income flow from 6 the household and firms to the government. Government spending is in the form subsidies, factor payments and transfer payments. Tax form leakage from the circular flow but government expenditure constitutes injections into the circular flow. It is shown by dotted lines in the diagram. Interaction between domestic country and rest of the world is shown by the dotted lines. It takes place through flow of goods and services and flow of factor services (International trade). The household and business sectors buy imported goods from abroad and makes payment to the foreign sector. On the other hand, these sectors get foreign remittances by exporting some factor services and goods and services abroad. The business sector exports goods and services (like shipping, insurance etc.) to foreign countries and receives payment in the form of receipts from exports, which is inflow in an economy. The business sector also makes payments to foreign sector for import of goods and services, which is outflow in an economy. Here Import (M) forms leakage from the circular flow but Exports (X) constitute injections in the circular flow. Equilibrium in the circular flow of income takes place when Leakages equals Injections. S+T+M=I+G+X S + T + M are the total withdrawals or leakages from the circular flow, while I + G + X are total injections into the circular flow of income. However, if S + T + M exceed I + G + X, income flow decreases, which reduces the level of economic activities in an economy. If I + G + X exceed S + T + M, income flow increases, which pushes up the level of economic activities in an economy. INSTRUCTIONS TO STUDY THIS CHAPTER: Please read your book for detailed information on the above topics. The length of the answer depends on the marks in the question paper and may not only be substituted with what is mentioned in the notes. Examples can be used to elaborate your points for this chapter. 7

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