Question

(i) Explain the concept of circular flow of income in a two-sector economy. (ii) “Gross Domestic Product (GDP) and sum of Gross Value Added (GVA) in…

Accepted Answer

(a) (i) 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. (ii) Gross Domestic Product (GDP) measures the market value of all the final goods and services produced within the domestic territory of a country, during an accounting year. Gross Value Added (GVA) measures the value addition by each production unit in an economy, during an accounting year. Therefore, the sum of Gross Value Added (GVA) by the three sectors is always equal to the Gross Domestic Product of the economy. OR (b) (i) No. GDP deflator is the ratio of Nominal GDP to Real GDP. Year Price (in ₹) Output (in units) Real GDP Nominal GDP GDP Deflator ( Nominal GDP )/( Real GDP ) × 100 --- --- --- --- --- --- 2010 10 100 1,000 1,000 (1,000)/(1,000) x 100 = 100 2015 15 100 1,000 1,500 (1,500)/(1,000) x 100 = 150 As indicated in the above example, the value of GDP is changing due to change in the prices only, the volume of output being unchanged. (ii) Factor income earned in the form of rent, royalties, interest and profits are together called ‘Income from Property and Entrepreneurship’

Year	Price (in ₹)	Output (in units)	Real GDP	Nominal GDP	GDP Deflator $\displaystyle \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$
$\displaystyle 2010$	$\displaystyle 10$	$\displaystyle 100$	$\displaystyle 1,000$	$\displaystyle 1,000$	$\displaystyle \frac{1,000}{1,000}$ x $\displaystyle 100$ = $\displaystyle 100$
$\displaystyle 2015$	$\displaystyle 15$	$\displaystyle 100$	$\displaystyle 1,000$	$\displaystyle 1,500$	$\displaystyle \frac{1,500}{1,000}$ x $\displaystyle 100$ = $\displaystyle 150$

(i)
Explain the concept of circular flow of income in a two-sector economy.
(ii)
“Gross Domestic Product (GDP) and sum of Gross Value Added (GVA) in an economy are always equal.”
Justify the given statement with valid arguments.

Marking-scheme solution

More from National Income Accounting