Circular Flow of Income

1
 Process of Income Generation and Circular Flow of
Income
Factor Incomes = Wages + Interest + Rent+ Profits = Factor Prices

FOP: Labour, Capital, Land, Organization

Household:
Firms:
Factor Owners and
Factor Users and
Customers
Producers
Goods and Services

Payments for Goods and Services = Value of Output

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 Circular Flow of Income in an Open Economy

11 Personal Savings
Financial Institutions
Deposits 1

13
Government Savings 5 Repayments
(+ve or –ve)
Corporate Tax
4 14
Investments
NDI + TP 8 Government Indirect Tax 2
Personal Tax 3 Subsidy
HDT
12
7 9 Govt. Exp.
6 [Rents+Wages+Interest+Profit]
Households Firms

FOP 10 Private Consumption GNP

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Footnotes: Receipts for
1. FOP : Factors of Production
exports (X)
2. GNP: Gross National Product 16
3. NDI : National Debt Interest of domestic debt Rest of the World Payments for imports (M)
4. TP : Transfer Payments 3
5. HDT: Household Direct Tax
Notes to Circular Flow of Income
A. Assumptions Underlying the Circular Flow of Income
i. All production takes place at firms
ii. All investments are made by firms
iii. All savings go to financial institutions

B. Circular flow of income shows following leakages (withdrawals) from

the national income, which do not form a part of expenditure on
national product:
Savings (S), Taxes (T) and Imports (M)

C. Also it indicates following injections (additions) into expenditure on

national product, which do not come from national income:
Investments (I), Government Expenditure (G) and Exports (X)

D. In equilibrium total planned leakages must equal total planned

injections; i.e.,
S+T+M=I+G+X

E. In an open economy there can be 3 gaps i.e.,

S ≠ I (Saving – investment gap) ; T ≠ G (fiscal deficit/surplus) and M ≠ X
deficit/surplus on current account of BOP) 4
but the sum of the three gaps must equal zero