Consider a simple economy without a government, external trade or any savings. Households own the factors of production. They provide factor services to the firms, and the firms make factor payments to them as wages, interest, profit and rent. Households spend their entire income on the goods and services produced by the domestic firms. So the factor payments made by the firms come back to them as sales revenue, and the aggregate income of the economy goes round the two sectors, firms and households, in a circular way.
Suppose households in this economy start saving a part of their income. What happens to the conclusion that the aggregate income estimated by the product, expenditure and income methods is the same?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → It still holds.
Adding savings to the simple model does not change the main result. The three methods still give the same estimate of income.
Option (1) It still holds. — Correct. However complicated the economy, the three methods give the same annual production.
Option (2) It no longer holds, because household spending becomes smaller than the factor payments. — Incorrect. Savings make the model more realistic, but the three estimates stay equal.
Option (3) It holds only for the product and income methods, not for the expenditure method. — Incorrect. All three methods measure the same flow at different points, so none of them breaks away.
Option (4) It holds only if the firms do not hold any inventories. — Incorrect. Inventories are counted as investment, so they do not upset the equality.
NCERT (2026-27): “2.2 Circular Flow of Income and Methods of Calculating National Income … If we change our simple model described above and introduce savings, will it change the principal conclusion that the aggregate estimate of the income of the economy will remain the same whether we decide to calculate it at A, B or C? It turns out that this conclusion does not change in a fundamental way. No matter how complicated an economic system may be, the annual production of goods and services estimated through each of the three methods is the same. …” |