Question

Discuss briefly the concept of circular flow of income in a two-sector model. “Real Gross Domestic Product (GDP) is a better indicator of economic…

Accepted Answer

(a) In a two-sector economy model, households are the owners of factors of production (Land, Labour, Capital, Entrepreneur). Firms combine these factors of production to produce goods and services. They make factor payments (Rent, wages, Interest, Profits) to households, which in turn, are spent by the households on the consumption of final goods and services. Thus, the income earned by the factors of production flows back to the production units in the form of aggregate consumption expenditure. Thereby, completing the circular flow of income. (b) Yes. Real Gross Domestic Product (GDP) is the money value of all the final goods and services produced in the domestic territory of an economy, measured at base year prices. Whereas, Nominal Gross Domestic Product (GDP) is money value of all the final goods and services produced in the domestic territory of an economy, measured at current year prices. For example: Year Price (in ₹) Output (in units) Real GDP (P 0Q 1) Nominal GDP (P 1Q 1) --- --- --- --- --- 2010 (Base Year) 10 100 1,000 1,000 2011 (Current Year) 15 100 1,000 1,500 Real GDP is a better indicator to make comparison in terms of physical output and it eliminates the effect of price change.

Year	Price (in ₹)	Output (in units)	Real GDP $\displaystyle (P_0Q_1)$	Nominal GDP $\displaystyle (P_1Q_1)$
$\displaystyle 2010$ (Base Year)	$\displaystyle 10$	$\displaystyle 100$	$\displaystyle 1,000$	$\displaystyle 1,000$
$\displaystyle 2011$ (Current Year)	$\displaystyle 15$	$\displaystyle 100$	$\displaystyle 1,000$	$\displaystyle 1,500$

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