Circular Flow of Income

Ms. Priti Gulati

Economy

What is an Economy? Economy is an integrated system of production, exchange and consumption. People enter in to many economic transactions of buying and selling goods and services to carry out these functions.

Economic transactions generate two kinds of flows:

Product or Real flow ( flow of goods and services) Money flow

Product flow consists of either factor flow i.e. flow of services or goods flow Both product and money flows in opposite direction and in circular fashion.

Interdependence of goods and factor markets

FIRMS (suppliers of goods and services, demanders of factor services)

HOUSEHOLDS (demanders of goods and services, suppliers of factor services)

What sectors make up an Economy?

Household Sector Business sector or the Firms Government Sector Foreign or International Sector

These 4 sectors combine to form following 3 models:

2 Sector model including the households and the firms. 3 Sector model including the households, firms and the Government Sector. 4 Sector model including the households, firms, Government and the Foreign Sector.

Circular Flow of Income and Expenditure in a 2 Sector Model

2 Sector model represents a closed private economy, an unrealistic model. Features of Households:

Owners of all factors of production. Income consists of rent, wages, interest and profit. Consumers of all goods and services. Spend their total income on consumption, if any par of income is saved, it is invested in firms. Own no resources of their own. They hire and use factors of production. They produce and sell goods and services. They do not save.

Features of Firms:

2 Sector Model

From the diagram, we can figure out :

Y FP FP w r i p FP V M Thus, V Y M

Withdrawals, Injections and the size of flows

The magnitude of income and expenditure flows depends on the societys income and expenditure: the larger the size of income, the larger the size of flows and vice versa. In reality, there are leakages (withdrawals) and additions (injections) to the circular flow of income. A withdrawal is the amount set aside by the households and firms and is not spent on domestically produced goods and services. Thus, saving is a withdrawal. It reduces the size of flows.

When savings are spent in the form of investment, it takes the shape of injections. An injection is the amount that is spent by households and firms in addition to the income generated with in the regular economy. An injection by the household is the expenditure that they make in addition to what they receive from the firms as factor income. The injection by the household may be in the form of spending inherited savings, own hoardings, or by borrowing and spending on consumer goods.

The injection by the firms is the expenditure what they make in addition to what they receive on selling goods and services. They inject money by spending their past savings or by borrowing from the outside. Injections increase the size of flows.

Withdrawals and injections in circular flows

The 2 sector model with savings

In reality, households do save a part of their income for investment. Thus, role of financial sector comes in to existence. Financial sector includes banks and other financial intermediaries that accept deposits and invest it in the business sector. Thus, household income consist of consumption expenditure (C) and savings (S).

C and S take different routes. C flows directly to the firms. S is routed through financial sector and become Investment (I).

Circular Flow of Income and Expenditure in a 3 Sector Model

3 sector model is formed by adding Government sector to 2 sector model. Depicts a more realistic economy. The inclusion of Government sector involves the addition of 3 variable: direct taxes, government spending on goods and services and transfer payments to the circular flow. Taxes are withdrawals as they reduce private disposable income and therefore consumption expenditure and savings.

Government expenditure is an injection as it increases aggregate demand in the form of government purchases. Transfer payment is an injection which adds to the household income resulting in increase in households demand for consumer goods and services.

Circular Flow in a 3 sector model

The magnitude of flows between the households and the firms is reduced because a part of households and firms income flows in the form of direct and indirect taxes to the government sector. The government spends a part of their income on wages, salaries and transfer payments to the households and a part of it on purchases from the firms and payment of subsidies. Thus, the money that flows from the household and firms to the government in the form of taxes flows back to these sectors in the form of government expenditure.

Is the Government tax Revenue (T) always equal to Government Expenditure (G)?

It depends on government budgetary policy. Balanced budget policy, G=T Deficit budget policy, G > T. It implies net injections to the economy. Surplus budget policy, G < T. it implies net withdrawals from the economy.

Circular Flow of Income and Expenditure in a 4 Sector Model

It represents an open economy with the inclusion of Foreign Sector. Foreign sector consists of two kinds of international transactions:

Foreign trade i.e. export and import of goods and services. Inflow and outflow of capital

Assumptions of 4 sector model

The external sector consists of export and import of goods and services. The export and import of goods and non labor services are made only by the firms. The households exports only labor.

Export (X) makes goods and services flow out of the country and make money flow in to the country. Thus, export represents injections. Imports (M) make inflow of goods and services and flow of money out of the country. Thus, import represents withdrawals.

If X> M, increases the magnitude of circular flows. If X<M, decreases the magnitude of circular flows. If X=M, no affect on circular flows.