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Income determination and circular flow of income

Income determination 

The basic objective of macroeconomics is to develop theoretical tools, called models, which attempt to provide theoretical explanation to questions such as what causes periods of slow growth or recessions in the economy, or increment in the price level, or a rise  in unemployment.  

It is difficult to account for all the variables at the same time. Thus, when we concentrate on the determination of a particular variable, we must hold the values of all other variables constant. 

We apply the same method in the analysis of the macroeconomic system for  the determination of National Income under the assumption of fixed price of final goods and constant rate of interest in the economy. 

Circular flow of goods and services 

There may fundamentally be four kinds of contributions that can be made during the production of goods and services  

(a) contribution made by human labour, remuneration for which is called wage  

(b) contribution made by capital, remuneration for which is called interest  

(c) contribution made by entrepreneurship, remuneration of which is profit  

(d) contribution made by fixed natural resources (called ‘land’), remuneration for which is called rent. 

  • Year after year we can imagine the aggregate income of the economy going through the two sectors, firms and households, in a circular way. When the income is being spent on the goods and services produced by the firms, it takes the form of aggregate expenditure received by the firms.  
Machine generated alternative text:
Goods and Services 
Factor Payments 
Factor Services

Since the same amount of money, representing the aggregate value of goods and services, is moving in a circular way, if we want to estimate the aggregate value of goods and services produced during a year we can measure the annual value of the flows at any of the dotted lines indicated in the diagram.  

1.We can measure the uppermost flow (at point A) by measuring the aggregate value of spending that the firms receive for the final goods and services which they produce. This method will be called the expenditure method.  

2.If we measure the flow at B by measuring the aggregate value of final goods and services produced by all the firms, it will be called product method.  

Value added of a firm is, value of production of the firm – value of intermediate goods used by the firm. The  value added of a firm is distributed among its four factors of production,  namely, labour, capital, entrepreneurship and land. Therefore wages, interest,  profits and rents paid out by the firm must add up to the value added of the firm. Value added(net contribution) is a flow variable. 

3.At C, measuring the sum total of all factor payments will be called income method. 

February 2024