Circular flow of income or circular flow

Refers to a simple economic model which

describes the reciprocal circulation of income
between producers and consumers.

In the circular flow model, the inter-

dependent entities of producer and consumer
are referred to as "firms" and "households"
respectively and provide each other with
factors in order to facilitate the flow of income.

Real Flow and Money Flow. Real Flow- In a

simple economy, the flow of factor services
from households to firms and corresponding
flow of goods and services from firms to
households s known to be as real flow.
Firms
 Provide consumers with goods and services in exchange for consumer
expenditure and "factors of production" from households.
 Human wants are unlimited and are of recurring nature
therefore, production process remains a continuous and demanding
process. In this process, household sector provides various factors of
production such as land, labor, capital and enterprise to producers who
produce by goods and services by coordinating them. Producers or
business sector in return makes payments in the form of
rent, wages, interest and profits to the household sector.
 Household sector spends this income to fulfill its wants in the form of
consumption expenditure.
 Business sector supplies those goods and services produced and get
income in return of it.
 Thus expenditure of one sector becomes the income of the other and
supply of goods and services by one section of the community becomes
demand for the other.
 A continuous flow of production, income and
expenditure is known as circular flow of income. It is
circular because it has neither any beginning nor an
end. The circular flow of income involves two basic
assumptions

1. In any exchange process, the seller or producer

receives the same amount what buyer or consumer
spends.
2. Goods and services flow in one direction
Money Flow
 In a modern two sector economy, money acts as a medium
of exchange between goods and factor services.
 Money flow of income refers to a monetary payment from
firms to households for their factor services and in return
monetary payments from households to firms against their
goods and services.
 Household sector gets monetary reward for their services
in the form of rent, wages, interest, and profit form firm
sector and spends it for obtaining various types of goods to
satisfy their wants. Money acts as a helping agent in such
an exchange.
Two Sector Model
 In the simple two sector circular flow of income model
the state of equilibrium is defined as a situation in which
there is no tendency for the levels of income
(Y), expenditure (E) and output (O) to change,
Y=E=O
 This means that the expenditure of buyers (households)
becomes income for sellers (firms). The firms then spend
this income on factors of production such as labour, capital
and raw materials, "transferring" their income to the factor
owners. The factor owners spend this income on goods
which leads to a circular flow of income.
Three Sector Model
 It includes household sector, producing sector and government
sector.
 It will study a circular flow income in these sectors excluding rest
of the world i.e. closed economy income.
 Here flows from household sector and producing sector to
government sector are in the form of taxes.
 The income received from the government sector flows to
producing and household sector in the form of payments for
government purchases of goods and services as well as payment
of subsides and transfer payments.
 Every payment has a receipt in response of it by which aggregate
expenditure of an economy becomes identical to aggregate
income and makes this circular flow and unending.
Four Sector Model
 A modern monetary economy comprises a network of four
sector economies this are-
1.Household sector
2.Firms or producing sector
3.Government sector
4.Rest of the world sector.
 Each of the above sectors receives some payments from the
other in lieu of goods and services which makes a regular
flow of goods and physical services. Money facilitates such
an exchange smoothly.
 A residual of each market comes in capital market as saving
which inturn is invested in firms and government sector.
Five sector model
Five sector model
 The five sector model of the circular flow of income is a more realistic representation of the economy.
 The first is the Financial Sector that consists of banks and non-bank intermediaries who engage in
the borrowing (savings from households) and lending of money. In terms of the circular flow of
income model the leakage that financial institutions provide in the economy is the option for
households to save their money.
 This is a leakage because the saved money cannot be spent in the economy and thus is an idle asset
that means not all output will be purchased.
 The injection that the financial sector provides into the economy is investment (I) into the
business/firms sector.
 The leakage that the Government sector provides is through the collection of revenue through Taxes
(T) that is provided by households and firms to the government. For this reason they are a leakage
because it is a leakage out of the current income thus reducing the expenditure on current goods and
services.
 The injection provided by the government sector is Government spending (G) that provides collective
services and welfare payments to the community. An example of a tax collected by the government as
a leakage is income tax and an injection into the economy can be when the government redistributes
this income in the form of welfare payments that is a form of government spending back into the
economy.
 The final sector in the circular flow of income model is the overseas sector which transforms the
model from a closed economy to an open economy. The main leakage from this sector are imports
(M), which represent spending by residents into the rest of the world. The main injection provided by
this sector is the exports of goods and services which generate income for the exporters from overseas
residents.
Five sector model
 In terms of the five sector circular flow of income
model the state of equilibrium occurs when the total
leakages are equal to the total injections that occur in the
economy. This can be shown as:
Savings + Taxes + Imports = Investment + Government
Spending + Exports
S + T + M = I + G + X.
 This can be further illustrated through the fictitious
economy of Noka where:
S+T+M=I+G+X
$100 + $150 + $50 = $50 + $100 + $150
$300 = $300
Five sector model
 Therefore since the leakages are equal to the injections the
economy is in a stable state of equilibrium. This state can be
contrasted to the state of disequilibrium where unlike that of
equilibrium the sum of total leakages does not equal the sum of
total injections. By giving values to the leakages and injections
the circular flow of income can be used to show the state of
disequilibrium. Disequilibrium can be shown as:
S+T+M≠I+G+X
 Therefore it can be shown as one of the below equations where:
Total leakages > Total injections
P150 (S) + P250 (T) + P150 (M) >P75 (I) + P200 (G) + 150 (X)
Or
Total Leakages < Total injections
P50 (S) + P200 (T) + $125 (M) < P75 (I) + P200 (G) + P150 (X)
Five sector model
 The effects of disequilibrium vary according to which of the above equations they belong
to.
 If S + T + M > I + G + X the levels of income, output, expenditure and employment will
fall causing a recession or contraction in the overall economic activity. But if S + T + M < I
+ G + X the levels of income, output, expenditure and employment will rise causing a
boom or expansion in economic activity.
 To manage this problem, if disequilibrium were to occur in the five sector circular flow of
income model, changes in expenditure and output will lead to equilibrium being
regained. An example of this is if:
 S + T + M > I + G + X the levels of income, expenditure and output will fall causing a
contraction or recession in the overall economic activity. As the income falls (Figure 4)
households will cut down on all leakages such as saving, they will also pay less in taxation
and with a lower income they will spend less on imports. This will lead to a fall in the
leakages until they equal the injections and a lower level of equilibrium will be the result.
 The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the
levels of income, expenditure and output will greatly rise causing a boom in economic
activity. As the households income increases there will be a higher opportunity to save
therefore saving in the financial sector will increase, taxation for the higher threshold
will increase and they will be able to spend more on imports. In this case when the
leakages increase they will continue to rise until they are equal to the level injections. The
end result of this disequilibrium situation will be a higher level of equilibrium.
Significance of Study of Circular
Flow of Income
1.Measurement of National Income- National income is an estimation of
aggregation of any of economic activity of the circular flow. It is either
the income of all the factors of production or the expenditure of
various sectors of economy. However, aggregate amount of each of the
activity is identical to each other.
2.Knowledge of Interdependence- Circular flow of income signifies the
interdependence of each of activity upon one another. If there is no
consumption, there will be no demand and expenditure which in facts
restricts the amount of production and income.
3.Unending Nature of Economic Activities- It signifies that production,
income and expenditure are of unending nature, therefore, economic
activities in an economy can never come to a halt. National income is
also bound to rise in future.
4.Injections and Leakages Reference- A General Approach to
Macroeconomic Policy.
Difference between Real Flow and
Money Flow
1. Real flow is the exchange of goods and services between
household and firms whereas money flow is the monetary
exchange between two sectors.
2. In real flow household sector supplies raw
material, land, labour, capital and enterprise to firms and in
return firms sector provides finished goods and services to
household sector. Whereas in money flow, firm sector gives
remuneration in the form of money to household sector a wages
and salaries, rent, interest etc.
3. Difficulties of barter system for the exchange of goods and factor
services between households and firms sector in real
flow, whereas no such difficulty or inconvenience arise in money
flow.
4. When goods and services flow from one sector of the economy
to another, it is known as real flow.
Phases or Stages of Circular Flow
of Income
Production, consumption expenditure and generation of income are the three basic economic
activities of an economy that go on endlessly and are titled as circular flow of income.
Production gives rise to income, income gives rise to demand for goods and services ; such a
demand gives rise to expenditure and expenditure induces for further production. The whole
process forms the basis for circular flow of income and related activities- production, income
and expenditure are known as phases or stages of circular flow of income.

Production → Income → Expenditure → Production.

1. Production Phase- Production means creation of utility to satisfy human wants. It involves the co-ordination of all the
factors of production in some desired ratio. This job is performed by a producer or firm who takes an initiative with the
motive of earning profits. He hires land, labour, capital and an organization and makes them payment in the form of
rent, wages and salaries and interest. This phase is to produce goods and services and after selling them, it generates
income.
2. Income Phase- Producing firms earn revenue from the sale of goods and services produced by them. Whole of the
earning is divided between factors provided by household sector in the form of rent, wages, interest and profits. Such
an income is classified into three parts:- •Compensation of employees- Wages, salaries, commission, bonus etc.
•Operating Surplus- Profits, rent, interest, royalty etc. •Mixed Income- Income of self- employed Thus production
takes the shape of income of household sector.
3. Expenditure Phase- Household sector spends its income to satisfy unlimited and recurring human wants. Any saving
out of total income takes the shape of investment on capital goods that helps in generating the income of the economy.
Expenditure becomes the income of producing sector that promotes further the uninterrupted flow of income.
Gross national income
 The Gross national income (GNI) consists of: the
personal consumption expenditure, the gross private
investment, the government consumption
expenditures, the net income from assets abroad (net
income receipts), and the gross exports of goods and
services, after deducting two components: the gross
imports of goods and services, and the indirect
business taxes.
 The GNI is similar to the gross national product
(GNP), except that in measuring the GNP one does not
deduct the indirect business taxes.
GNI versus GDP
 For example, the profits of a Philippines-owned company
operating in the UK will only count towards PHL GNI and UK
GDP. If a country becomes heavily indebted, and pays large
amounts of interest to service this debt, this will be reflected in a
decreased GNI but not a decreased GDP. If a country sells off its
resources to entities outside their country this will also be
reflected over time in decreased GNI, but not decreased GDP.
Therefore, the GDP appears more attractive for countries with
increasing national debt and decreasing assets.
 GNP is a concept that goes hand in hand with GNI, GDP, and
NNI. In contrast to the GNI, the GNP does not account for the
balance of cross-country income, such as interest and dividends.
In contrast to the GDP, the GNP account for the values of
products and services based on citizenship of the owners rather
than the territory of the activity.
How to Calculate the GNI
GNI is an add up of Net Income from abroad and the GDP,
one can calculate the GNI by the following formula.

Measures of national income

and output
A variety of measures of national income and output are used in economics to
estimate total economic activity in a country or region, including gross
domestic product (GDP), gross national product (GNP), net national income
(NNI), and adjusted national income (NNI* adjusted for natural resource
depletion). All are especially concerned with counting the total amount of
goods and services produced within some "boundary”
The boundary is usually defined by geography or citizenship, and may also
restrict the goods and services that are counted. For instance, some measures
count only goods and services that are exchanged for money, excluding
bartered goods, while other measures may attempt to include bartered goods
by imputing monetary values to them.
National accounts
 Arriving at a figure for the total production of goods and
services in a large region like a country entails a large
amount of data-collection and calculation. Although some
attempts were made to estimate national incomes as long
ago as the 17th century,
 The systematic keeping of national accounts, of which
these figures are a part, only began in the 1930s, in the
United States and some European countries. The impetus
for that major statistical effort was the Great Depression
and the rise of Keynesian economics, which prescribed a
greater role for the government in managing an economy,
and made it necessary for governments to obtain accurate
information so that their interventions into the economy
could proceed as well-informed as possible.
Market value
 In order to count a good or service, it is necessary to assign value to it.
 The value that the measures of national income and output assign to a good or service is its market value – the
price it fetches when bought or sold.
 The actual usefulness of a product (its use-value) is not measured – assuming the use-value to be any different
from its market value.
 Three strategies have been used to obtain the market values of all the goods and services produced: the
product (or output) method, the expenditure method, and the income method.
 The product method looks at the economy on an industry-by-industry basis.
 The total output of the economy is the sum of the outputs of every industry. However, since an output of one
industry may be used by another industry and become part of the output of that second industry, to avoid
counting the item twice we use not the value output by each industry, but the value-added; that is, the
difference between the value of what it puts out and what it takes in.
 The total value produced by the economy is the sum of the values-added by every industry.
 The expenditure method is based on the idea that all products are bought by somebody or some organization.
 Therefore we sum up the total amount of money people and organizations spend in buying things.
 This amount must equal the value of everything produced. Usually expenditures by private
individuals, expenditures by businesses, and expenditures by government are calculated separately and then
summed to give the total expenditure. Also, a correction term must be introduced to account for imports and
exports outside the boundary.
 The income method works by summing the incomes of all producers within the boundary. Since what they
are paid is just the market value of their product, their total income must be the total value of the product.
Wages, proprietor's incomes, and corporate profits are the major subdivisions of income.
The output approach
 The output approach focuses on finding the total output of a nation by directly finding
the total value of all goods and services a nation produces.
 Because of the complication of the multiple stages in the production of a good or
service, only the final value of a good or service is included in the total output. This
avoids an issue often called 'double counting', wherein the total value of a good is
included several times in national output, by counting it repeatedly in several stages of
production. In the example of meat production, the value of the good from the farm may
be P10, then P30 from the butchers, and then P60 from the supermarket. The value that
should be included in final national output should be P60, not the sum of all those
numbers, P100. The values added at each stage of production over the previous stage are
respectively P10, P20, and P30. Their sum gives an alternative way of calculating the value
of final output.

 Formula:
GDP(gross domestic product) at market price = value of output in an economy in
the particular year - intermediate consumption
NNP at factor cost = GDP at market price - depreciation + NFIA (net factor
income from abroad) - net indirect taxes
The income approach
The income approach equates the total output of a nation to the total factor
income received by residents or citizens of the nation. The main types of factor
income are:
 Employee compensation (cost of fringe benefits, including
unemployment, health, and retirement benefits);
 Interest received net of interest paid;
 Rental income (mainly for the use of real estate) net of expenses of landlords;
 Royalties paid for the use of intellectual property and extractable natural
resources
All remaining value added generated by firms is called the residual or profit. If a
firm has stockholders, they own the residual, some of which they receive as
dividends. Profit includes the income of the entrepreneur - the businessman
who combines factor inputs to produce a good or service.

Formula
NDP at factor cost = Compensation of employees + Net interest + Rental &
royalty income + Profit of incorporated and unincorporated NDP at factor cost.
The expenditure approach
 The expenditure approach is basically an output accounting method. It focuses on
finding the total output of a nation by finding the total amount of money spent. This is
acceptable, because like income, the total value of all goods is equal to the total amount
of money spent on goods. The basic formula for domestic output takes all the different
areas in which money is spent within the region, and then combines them to find the
total output.
Where:
C = household consumption expenditures / personal consumption expenditures
I = gross private domestic investment
G = government consumption and gross investment expenditures
X = gross exports of goods and services
M = gross imports of goods and services
Note: (X - M) is often written as XN, which stands for "net exports"

GDP and Gross domestic product (GDP) is defined as "the value of all final goods and
services produced in a country in 1 year".
Gross National Product (GNP) is defined as "the market value of all goods and services
produced in one year by labor and property supplied by the residents of a country."
 As an example, the table below shows some GDP and GNP, and NNI
data for the United States:

 NDP: Net domestic product is defined as "gross domestic product

(GDP) minus depreciation of capital",[ similar to NNP.
 GDP per capita: Gross domestic product per capita is the mean value
of the output produced per person, which is also the mean income.
National income and welfare
 GDP per capita (per person) is often used as a measure of a person's welfare. Countries with higher
GDP may be more likely to also score highly on other measures of welfare, such as life expectancy.
However, there are serious limitations to the usefulness of GDP as a measure of welfare:
 Measures of GDP typically exclude unpaid economic activity, most importantly domestic work such as
childcare. This leads to distortions; for example, a paid nanny's income contributes to GDP, but an
unpaid parent's time spent caring for children will not, even though they are both carrying out the same
economic activity.
 GDP takes no account of the inputs used to produce the output. For example, if everyone worked for
twice the number of hours, then GDP might roughly double, but this does not necessarily mean that
workers are better off as they would have less leisure time. Similarly, the impact of economic activity on
the environment is not measured in calculating GDP.
 Comparison of GDP from one country to another may be distorted by movements in exchange rates.
Measuring national income at purchasing power parity may overcome this problem at the risk of
overvaluing basic goods and services, for example subsistence farming.
 GDP does not measure factors that affect quality of life, such as the quality of the environment (as
distinct from the input value) and security from crime. This leads to distortions - for example, spending
on cleaning up an oil spill is included in GDP, but the negative impact of the spill on well-being (e.g. loss
of clean beaches) is not measured.
 GDP is the mean (average) wealth rather than median (middle-point) wealth. Countries with a skewed
income distribution may have a relatively high per-capita GDP while the majority of its citizens have a
relatively low level of income, due to concentration of wealth in the hands of a small fraction of the
population.
Because of this, other measures of welfare such as the Human Development Index (HDI), Index of
Sustainable Economic Welfare (ISEW), Genuine Progress Indicator (GPI), gross national happiness
(GNH), and sustainable national income (SNI) are used.
Difficulties in Measurement of
National Income
 There are many difficulties when it comes to measuring national
income, however these can be grouped into conceptual difficulties and
practical difficulties.
Conceptual Difficulties
 Inclusion of Services: There has been some debate about whether to include services in the counting of
national income, and if it counts as output. Marxian economists are of the belief that services should be
excluded from national income, most other economists though are in agreement that services should be
included.
 Identifying Intermediate Goods: The basic concept of national income is to only include final
goods, intermediate goods are never included, but in reality it is very hard to draw a clear cut line as to
what intermediate goods are. Many goods can be justified as intermediate as well as final goods
depending on their use.
 Identifying Factor Incomes: Separating factor incomes and non factor incomes is also a huge problem.
Factor incomes are those paid in exchange for factor services like wages, rent, interest etc. Non factor are
sale of shares selling old cars property etc., but these are made to look like factor incomes and hence are
mistakenly included in national income.
 Services of Housewives and other similar services: National income includes those goods and services for
which payment has been made, but there are scores of jobs, for which money as such is not paid, also
there are jobs which people do themselves like maintain the gardens etc., so if they hired someone else
to do this for them, then national income would increase, the argument then is why are these acts not
accounted for now, but the bigger issue would be how to keep a track of these activities and include
them in national income.
 Practical Difficulties
 Unreported Illegal Income: Sometimes, people don't
provide all the right information about their incomes to
evade taxes so this obviously causes disparities in the
counting of national income.
 Non Monetized Sector: In many developing nations,
there is this issue that goods and services are traded
through barter, i.e. without any money. Such goods and
services should be included in accounting of national
income, but the absence of data makes this inclusion
difficult.