In this article we will discuss about the circular flow of income.
National income refers to the aggregate, or total, income of the nation which results from economic activity. Income, however, depends upon how much output is produced and as output is a continuous process rather than a stock, we have to increase this output over a specified time period, usually one year. Total output is referred to as national product, and includes all the goods and services produced each year.
National income was defined by Alfred Marshall as “the aggregate net product of and sole sources of payment to all agents of production.”
If we study this definition closely, we can identify three components:
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1. Aggregate net product, i.e., total output
2. Sole source of payment, i.e., incomes
3. All the agents of production, i.e., how the national product is distributed and, therefore, the source of all expenditure.
From this definition, we can identify three possible methods of measurement: output, income and expenditure.
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Measurement by either of these methods will produce identical results because theoretically:
National income = national output = national expenditure
In this context, we refer to circular flow of income which refers to the flow of payments and receipts between domestic firms and domestic households. Money passes from households to firms in return for goods and services produced by firms and money passes from firms to households in return for the factor services provided by households. The simple notion that the money value of the income of households must equal the money value of household’s expenditure to purchase this output provides the basis for national income accounting.
In order to understand the concept of income as a flow it is useful to study the circular flow of income in the form of a flow diagram. If Fig. 3 is studied closely, it can be seen that households supply productive services (factors of production like land, labour, capital and entrepreneurial talent) to firms and in return receive the factor rewards in the form of wages, rent, interest and profit.
These are the total of all incomes to households and will therefore form the basis of all expenditures. When expenditures are made with firms in the form of consumption then there must be an equivalent flow of goods and services from firms to households. It is, therefore, possible to measure each of these flows (of output income and expenditure) and achieve the same result.
Hence, the conclusion: national income = national output = national expenditure. In reality, the circular flow diagram, portrayed in Fig. 3 needs to be slightly modified. For example, much of national expenditure is in the form of investment expenditure between firms. However, it does not illustrate the concept of national income as a flow.