Question

(a) (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.

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.

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 $\displaystyle 100$ = $\displaystyle 150$

Marking-scheme solution

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(a) (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)…

Marking-scheme solution

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