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The Circular Flow of the Economy and Measuring National Income thru GNI and GDP and Adjusting for Inflation

Updated on October 30, 2015

Circular Flow of the Economy

Actors in the Circular Flow of Economy

Role Played
Consumes products but does not have the capability to produce them Is the source of the factors of production
Produces products for households, the government, and the external sector
Provides public services
External sector
Exchanges products and services with the national economy

Types of Markets

Role Played
Product market
Market for the finished goods or commodities
Factor market
Market for the factors of production
Financial market
Market where savings and investments occur
World market
Market where imports and exports occur

Guide Questions 1

  1. What does the circular flow of the economy show?
    The circular flow shows the interdependence among the different actors within an economy. They rely on each other in order to respond to their individual needs and wants.
  2. Why is there are a connection among the different sectors of an economy?
    The different sectors of an economy have to make decisions everyday that would involve the other sectors of the economy.

Importance of Measuring National Income

Campbell R. McConnell at Stanley Brue’s Economics Principles, Problems, and Policies (1999)

  1. It gives us an idea about the level of the production of an economy in a particular period and can help us explain why the production is high or low.
  2. By comparing with the previous periods, we can determine where the economy is heading.
  3. The information gained is useful in creating economic policies for the betterment of the individuals and the economic performance of the country.
  4. Without a systematic method to measure national income, there will be no valid basis for making economic policies. Everything would be guesswork.
  5. Through National Income Accounting, we can measure the health of the economy.

Gross National Income (formerly Gross National Product)

  • total market value of finished goods and services produced in the country
    • ready to be consumed by the consumer
    • the value of raw materials produced are not counted to avoid duplication
    • non-market activities not included if no money is raised from this (e.g. planting crops in the backyard for family’s consumption)
    • informal sector (underground economy) not included (e.g. street vendors)
  • usually measured per quarter or per year
  • can be measured in national currency, or for comparison, US Dollar

GNI vs. Gross Domestic Product (GDP)

  • GDP includes all factors of production even if it is owned by a foreigner living in a country
  • GNI includes the gains of all citizens even if they work in another country
  • Situation: Bong is a Filipino working in the US. Mel is from the US working in our country.


Ways to Measure GNI

General Rule: GNI = GDP + NFIFA

Expenditure approach (Formula: GNP = C + I + G + (X - M) + SD + NFIFA)

  1. Consumer spending – food, clothing, recreation, etc.
  2. Investment – office equipment, raw materials for production, employees’ salary, etc.
  3. Government spending – spending for community projects and other expenses
  4. Exports minus imports
  5. Statistical discrepancy
  6. Net factor income from abroad (net primary income) – expenditure of foreigners within the country minus expenditure of foreigners outside the country

Industrial origin/value-added approach
(Formula: GNP = Agriculture + Industry + Service + NFIFA)

Income approach

  1. Employees’ salary
  2. Net operating surplus – profit of private/public businesses
  3. Depreciation
  4. Indirect taxes – sales taxes, custom duties, licenses, etc.
  5. Subsidies

Current/Nominal vs. Real/Constant

  • Current/Nominal – based on the current prices in the market
  • Real/Constant – based on the prices of the base year’s market, adjusting for inflation
    • Smaller and more believable because it is not affected by
  • Price index = (Price in current year/Price in base year)(100)
  • Real GNI = (Price index base year/Price index current year)(Current GNI)
  • Growth rate = {(GNI current year - GNI previous year)/GNI previous year} (100)
  • Income per capita = (GDP / total population of the country)
    • The less population, the more income per capita, the better for the citizens

Limitations in Measuring National Income

  • Non-market activities
    • GNI does not account for other worthwhile activities, such as taking care of children, washing plates, and planting in the backyard
  • Informal sector
    • Illegal activities such as transactions in the black market, the market for illegal drugs, stolen products and cars, illegal gambling and the like are not accounted for
    • So are legal activities not accounted to the government like selling used cars and rent for garbage dumping
  • Externalities
    • The expenditure of a company to minimize pollution is accounted for, while the value of having a clean environment isn’t.
  • Quality of life
    • While it is said that the higher the national income, the better the economic condition of the people, it cannot be concluded that this will result to greater happiness. Many factors that are essential to the betterment of the lives of the people, such as a clean environment, adequate hours of sleep, and a healthy living is not counted.


Nominal GNP
Price Index
Compute for the Real GNP. Use 2006 as the base year.

Guide Questions 2

  1. What does the price index measure?
  2. Why is the Nominal GNP often higher than the Real GNP?
  3. What are the implications of having a large population but a small GNI in this contemporary times?


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    • ChechuDigital profile image

      Chechu Siscar 2 years ago from Lipa, Philippines

      Thank you, Cutie :)

    • profile image

      Cutie 2 years ago

      Very good.

    • ChechuDigital profile image

      Chechu Siscar 2 years ago from Lipa, Philippines

      Thanks, HSchneider!

    • profile image

      Howard Schneider 2 years ago from Parsippany, New Jersey

      Very well presented overview of these economic concepts and factors that we use to measure economic activity. Excellent Hub, Chechu.