CIRCULAR FLOW OF INCOME

Table of Contents
INTRODUCTION: ........................................................................................................................................ 3
Household Sector ...................................................................................................................................... 4
Firms.......................................................................................................................................................... 4
Government .............................................................................................................................................. 4
Rest of the World ...................................................................................................................................... 4
Financial Sector ......................................................................................................................................... 4
Two sector model: ................................................................................................................................ 5
Three Sector Model: ................................................................................................................................. 5
Four Sector Model: ................................................................................................................................... 6
Five Sector Model of Economy: ................................................................................................................ 6
Leakage and injection: .................................................................................................................................. 7
LEAKAGE:................................................................................................................................................... 7
INJECTION: ................................................................................................................................................ 7
Relationship between Demand and supply and Circular flow Model ....................................................... 8
DEMAND ................................................................................................................................................... 8
SUPPLY: ..................................................................................................................................................... 9
COMPARISION BETWEEN DEMAND AND SUPPLY: ................................................................................... 9
FACTOR EFFECTING DEMAND AND SUUPLY: .......................................................................................... 10
Price of commodity: ............................................................................................................................ 10
Price of inputs: .................................................................................................................................... 10
Expectations ........................................................................................................................................ 10
Prices of related goods: ...................................................................................................................... 10
Personal disposals income: ................................................................................................................. 10
Consumer’s choice and preferences: .................................................................................................. 10
Substitute products:............................................................................................................................ 11
Taxes ................................................................................................................................................... 11
HOW DEMAND AND SUPPLY WORKS: .................................................................................................... 11
CONCLUSION:.............................................................................................................................................. 11

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INTRODUCTION:
Money is transaction involving the transfer of goods and services from one person to another. It
is source to fulfill basics needs. Money makes the world go around. Economics rely on the
exchange of money for products and money. Money is the blood of economic system its flow is
very important for economy of any country. Circular flow of income is model of economy in
which major exchange are represents as a flow of money goods and services etc between
economic agents. Circular flow of money shows transfer of money resulting in flow of money
from one source to other. Circular flow is basically a model that depicts flow of money from one
individual or group of people to another group or individual. It represents exchange or flow of
money that is blood of any economy. It also indicates the concept of interdependence of one
economic factor on another economy to complete the cycle. (Mankiw, 2006) .The flow of money
is equal in magnitude and opposite in direction. Therefore, the circular flow illustrates the flow
of money throughout the economy.

Economic agents are individuals or organizations that influence the economy. In general there
are four types of economic agents:

ECONOMIC FLOW OF INCOME:

Circular flow income is economic model depicted how money flow through the economy. The
circular flow of economy is the way to representing the flow of money between two main groups
producers and consumers. Free market economy consists of two components, firms and
households.

Figure 1: Circular flow of economy

In figure 1, firms are those sectors that are main producer of goods and services. They supply
these services to consumers. Households are suppliers of different factors for the firm that

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includes Capital, Land and Work force. Households sell their services to firms and exchange
receives swage, household spend this income on goods and services and in exchange receive the
goods and services themselves.

Models of economic circular flow:

There are different classifications of economic circular flow based on the sectors that are
involved in each cycle. The factors of the circular flow model are stated and briefly explained
below:

Household Sector
The sector includes consumers of services and products. It also provides different
resources like Capital, Land and workforce that are necessary for production of products
in the factory. They provide money to the firms that are providing them goods and
services

Firms
The producers of goods and services are incorporated in this sector. They are the
manufacturers and they provide services and goods to the household sector. They are the
most important sector of the economic circular flow as it is basically the flow of money
by exchange of services between household sector and firm.

Government
The role of government in economic circular flow is collection of taxes from all other
sectors. It also includes the provision of services by the government

Rest of the World

This sector expands the scope of cycle of economy and provides an open economy. They
include dealing and trading with other countries. The basic activities involved in it are
activities of Imports and Exports of country. They broaden the scope of trade of any firm.
Foreign sector is the sector that includes facility of import and export in Circular flow model.
This sector also depends upon demand and supply because volume of flow of economy in
Circular flow model is dependent on it.

Financial Sector
The financial sector involves buying or lending money to firms. It includes many banking and
the non-banking institutions. It plays an important role in economic circular flow.

Following are different types of models based on the number of sectors that are used in
the model.

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Two sector model:
In this model there are two main sectors of economy that are Firms and Households. This model
assumes that there is no government, financial or foreign sector. (Hall:, 2005)

This model assume that

 Households spend all of their income to on goods and services.

 Households purchase all output produce by firms.

All households’ expenditure becomes income for firms. The firm than spend all of income to on
factors of production such as labor, capital and raw material, transferring all of their income to
factor owners. The factors owners than spend all of their income on goods, which leads to a
circular flow of income.

Figure 2: Two sector model of circular flow

Three Sector Model:

This flow of economy consists of three main sector that are firms, household and government. It
excludes the foreign and financial sector. Flow from households and firm to government are in
the form of taxes. The government receives flow to form to households in the form of subsidies,
transfer and purchase of goods and services. Every flow of money has a corresponding flow of
goods in opposite direction. The first role is to provide the firm with factors that are necessary
for production of goods and services. The second role that is played by household sector is role
of consumers of products and services and providing them with money in return. . The sector
model does not involve any concept of savings and there is no involvement of other three sectors
that are Government, foreign sector or financial sector.

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 Figure 3: Three sector model of circular flow

Four Sector Model:

The four sector model includes households, firms, government and rest of the world. It excludes
the financial sector. The foreign sector comprises foreign trade, inflow and outflow of capital.
Each flow of money has a corresponding flow of goods in opposite direction. Each of sectors
receives some payment in returnee of goods and services which makes regular flow of goods and
services. (Kotula, 2004)

Figure 5: Four sector model of economy

Five Sector Model of Economy:

The five sector model includes households, firms, government, rest of the world and financial
sector. The households play a role in inflow and outflow of by providing firm factor. Firms are

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providers of goods and services. Government collects taxes. The world plays a role in export and
import of goods and services. The financial sector includes the saving and investment.

Figure 6: Five sector model

Leakage and injection:

LEAKAGE:
Leakage is the withdrawal of from flow of money. It is outflow and reduction from the normal
flow of money. It is not present in two sector model. The factors includes in leakage is tax,
saving and import. They can result in decrease in flow of money.

INJECTION:
Injection means introducing the income into the flow. Injection increases the flow of income.
Leakage includes investment, exports and government expenditure. If we conceder two sector
model it is mostly not included in that model. (James Gwartney, 2004)

Figure 7: Leakage and injection.

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The major sources of leakage and sources are:

In two sector economy:

Leakage: saving (S)

Injection: Investment (I)

In three sector economy:

Leakage= saving (S) + taxes (T)

Injection= Investment (I) + Government Expenditure (G)

In four sector economy:

Leakage = saving (S) + Taxes (T) + import (M)

Injection = investment (I) + government expenditure (G) + Export (X)

Relationship between Demand and supply and Circular flow Model

There is interconnection between demand and supply. Demand is the desire of the buyer and his
ability to pay for the commodity at a specific price. Supply is the quantity of commodity which
is made available by the producer. There is inverse relation between demand and supply, when
demand increase supply decrease vice versa.

DEMAND
Demand represents the customer desire and performance for a particular product. The quantity of
product is demanded at certain price.

Figure 8: Demand curve

Demand curve show that there is inverse relation between price and quantity demand.

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SUPPLY:
Supply represents amount of particular product and services offered by producer at certain price
to customer.

Figure 9: Supply curve

Supply curve shows that there is direct relationship between price and quantity supplied.

COMPARISION BETWEEN DEMAND AND SUPPLY:

Basics for comparison Demand Supply

Definition Demand is desire of a buyer Supply is quantity of

and ability to pay for a commodity which is made by
particular commodity at producer to customer at
specific price certain price.
Curve Downward sloping Upward sloping
Interrelationship Inverse relationship between Direct relationship between
demand and supply demand and supply
Impact on prices With increase in prices Supply increase in supply
demand decrease and vice prices increase vice versa
versa
Representation Customers Firms.

The demand and supply are deeply related with circular economic flow because the flow depicts
the flow of money and supply and demand effect money flow. If there is greater demand than
firms have to produce more products and provide more services and there will be greater outflow
of money from firms. If the demand is lower, firms will produce less products and overall flow
of money will decrease. If demand and supply are more then, more flow of money is present and
vice versa. If the supply is higher, there is an option of exporting it to other countries or global
market and maximize the profit. On the other hand, if the demand is more than the production

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there is a need of importing the product from other countries. The balance between demand and
supply is vital for stability of Circular flow model. (Daly, 2006)

FACTOR EFFECTING DEMAND AND SUUPLY:

Price of commodity:
If the price of commodity increase than it is less demand by people because people need less
utility in the products. In this way demand decrease with increase in supply. The overall effect on
flow of money is negative by increasing price of products.

Price of inputs:
The price of inputs has a great impact on the price of commodity. If the cost of production raises
it ultimately results in falls in demand and supply for goods will also falls. The overall effect on
flow of money is negative by increasing price of inputs. This is the way by which inflation
influences circular flow. (Daly, 2006)

Expectations
If a customer higher expectation from a product and service, then the demand of that product will
be higher. The product should be efficient enough to meet the expectations of people to generate
more profit. Greater the supply and demand of any product, Greater is the economic flow in
Circular flow model.

Prices of related goods:

It can be understood by the example. If the prices of product raises the demand of motor cycle
falls while its supply increases, but if the prices of petrol falls people can easily afford to travel
on motorcycles. Those results in rises in demand and supply will rise. The demand and supply of
related goods also effect circular flow of income. Suppose a electronic company that sets a
relatively higher price of its new model as compared to its competitors, there is a strong
possibility that the product will have a lower demand and people will buy its cost-efficient
alternative device. The high price will have a negative impact on Circular flow model.
(Blanchard, 2002)

Personal disposals income:

If there is increase in the income of customer than there is slightly change in the price of
commodity will not affect the demand and supply. In this way he will demand less or switch to
other products. The higher income will have a positive impact on volume of flow of economy in
Circular flow model. The buying capacity of customers deeply effect the demand supply chain
ad in a long run effect circular flow of income.

Consumer’s choice and preferences:

If the products offer by the suppliers suits the customer choice than the customer surly demand
more and its supply will falls shorter because of its high demand. The choice of customers has

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deep impact on demand and supply of any particular product. It will affect the rate of flow of
circular flow of income.

Substitute products:
This can also be understood by an example. If there is rise in prices of coffee than most people
will leave to drink the coffee and people start to drink tea. This will suddenly affect the demand
and supply for both tea and coffee. The demand of tea will rise and supply will fall while the
demand of coffee will falls and supply will falls. If there is availability of alternative at lower
price, rate of supply and demand is deeply affected by it. Cycle of economic flow is influenced
deeply by availability of substitute products. For example, the customers have changed their
selection criteria and have shifted to IPhone and it had a significant effect on Android Company
that was leading producers of mobile phone. The change in preference of customer has a very
significant impact on demand of any product and service. It has a significant impact on flow of
money in economic cycle.

Taxes
The taxes have great impact on supply and demand cycle. Higher the taxes imposed on
production companies, lesser will be the supply of product. Higher rate of taxes will have a
negative impact on flow of economy in circular flow model.

HOW DEMAND AND SUPPLY WORKS:

Let suppose a company sets the price of its product is $10 no one wants the products so the price
will lower to $ 9. Demand for the product increase at the new lower prices and the company
begins to make the money and a profit.

The company could lower the prices to $5 to increase the demand even more. But most of the
people will not make up the money loss when the price point was lowered from $9 to $5. The
company leaves the prices sets at $9 that is the point at which supply and demands are in
equilibrium. Raising the prices will reduce the demand and makes the company less profitable
would not increase the demand to make up the money lost.

CONCLUSION:
The circular flow model is very useful for an economy. It plays a vital role in understanding the
economy. Circular flow model is important within the economy because it measures the national
income, provide knowledge of interdependence, and illustrate the ending less nature of nature of
economic activities. Circular flow model has different sectors and these sectors are
interconnected with the factor demand and supply. Different economic agents that include firms
and household sector depend on factors of demand and supply of products and services.

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