Circular Flow of Income:

It is a simple economic model that shows the movement of goods and services
and factors of production between producers and consumers within a
economy. It also refers to the flow of goods and services among the various
sectors of the economy balanced by the monetary payments made in
exchange for those goods and services. It is called so because the movement of
income and expenditure continues throughout the economy and repeats itself
forming the circular flow of income. In the circular flow model the expenses
made by one sector becomes the income for the other sector and the goods
and services produced by the firms is demand made by the economy.
Assumptions:
1. Household spend their whole income on goods and services produced
by the firms.
2. Firms produce goods and services demanded by the household only.
3. In case of two or three sector closed models, there is no inflow or
outflow of income and expenditure from any outside sources.
4. In the case of four sector, the foreign sector consists of imports and
exports of goods and services made by the firm.
There are two kinds of flows generated in transactions :
1. Real flow: It includes the flow of factors of production from the
household sector to the business sector and the corresponding flow of
goods and services from the business sector to the household sector.
2. Monetary Model: It includes the flow of rent, wage, interest and profit to
the household sector from business sector for hiring factors of production
and on the other hand, the consumption payment flow from household to
the business sector.
Agents of Circular Model: 1. Household, 2. Business, 3. Government and 4.
Foreign
Importance of Circular Flow of Model:
1. It helps in analyzing the problem of disequilibrium.
2. It helps in analyzing the effects of leakages and injection.
3. It creates a link between consumer and producer.
4. It creates a network of markets.
5. It helps to measure the inflationary or deflationary.
 6. It highlights the importance of monetary and fiscal policies.
Circular Flow Model in Two Sector Economy
In two sector circular model, there are household and business sector.
There is absence of government. The household sector is source of
factors of production like land, labor and capital. Business sector is the
source of goods and services.
Assumptions:
a) There are only two sectors in the economy i.e. household and
business.
b) Household spend all its income on consumption i.e. there is no
saving.
c) Firms are able to produce exact quantity of goods and services
which household sector demands.
d) There is no government intervention.
e) Business sector do not carry out any import or export quantities.
There are two circles in the circular flow model. The inner circle represents the
monetary flow and the outer circle represent the real flow.
a. Real Flow
It indicates the flow of factors of production from household sector to the
business sector for producing goods and services and flow of goods and sectors
from business sector to the household sectors for consumption.
b. Monetary flow
It indicates the flow of rent, wage, interest and profit to the household sector
from business sector to the household sector for hiring factors of production.
On the other hand, the consumption payment flows from household sector to
the business sector for consuming goods and services.
Three Sector circular Model
In three sector economy, there are household, business and government
sector. There is government intervention. Besides the income and expenditure,
there is government purchases or expenditure and taxation come into play.
Government purchases are injections while taxation is leakages.
Assumptions :
 a) There are three in the sectors: Household, Business and Government
Sector.
b) There is provision of saving.
c) There is government intervention.
d) Business sector do not carry out any import or export activities.
From the view point of the circular flow of income, each sector has dual roles
to play in the economy while a sector receives a certain payment from the
other sectors, it pays back to those sectors as well. The circular flow of income
in different sectors can be expressed as follows:
1. Household Sector
It owns factors of production and supplies to business and government sector.
It consumes goods and services produced by the business sector. It supplies
factors of production to the business and government sector.
i. Receipts
It receives the factor income in the form of rent, wages, interest and profit
from the business sector and government sector for supplying factors of
production. It also receives the transfer payments from the government
sector.
ii. Payment
The income of the household sector flows into the business sector,
government sector and capital market in the form of consumption
expenditure, tax and saving respectively.
2. Business Sector
It produces and supplies goods and services in the economy and hires factors
of production from the household sector.
i. Receipts
It includes income from the sale of goods and services from household sector
and government sector. It borrows money from the capital market. It also gets
subsidies from the government sector.
ii. Payment
It includes the factors payments and tax payments to the household sector and
government sector respectively.
3. Government Sector
It has the authority to pass rules and regulation, laviate taxes to the household
sector and business sector, hires factors of production from the household
sector and purchases goods and services from the business sector.
i. Receipts
The major source of the income for the government sector include the taxes
paid by the households and business sectors. It also receives interests and
dividends for the investments paid.
ii. Payment
It pays to the business sector in the return for the goods and services
purchased and also provides subsidies. It pays factor payments to the
household and also makes transfer payments to the household.
Four Sector Circular Model
It provides a realistic picture of the circular flow in an economy. It studies the
circular flow in an open economy which comprises of the household, business,
government and foreign sector. The foreign sector has the important role in
the economy. When the domestic business firm export goods and services to
the foreign markets, injections are made into the circular flow model. On the
other hand, when the domestic household firms or the government imports
something from the foreign sector in the circular model. From the view point
of the circular flow of income, each sector has dual roles to play in the
economy while a sector receives a certain payment from the other sectors, it
pays back to those sectors as well. The circular flow of income in different
sectors can be expressed as follows:
1. Household Sector
It owns factors of production and supplies to business and government sector.
It consumes goods and services produced by the business sector. It supplies
factors of production to the business and government sector.
i. Receipts
It receives the factor income in the form of rent, wages, interest and profit
from the business sector and government sector for supplying factors of
production. It also receives the transfer payments from the government
sector.
ii. Payment
The income of the household sector flows into the business sector,
government sector and capital market in the form of consumption
expenditure, tax and saving respectively.
2. Business Sector
It produces and supplies goods and services in the economy and hires factors
of production from the household sector.
i. Receipts
It includes income from the sale of goods and services from household sector
and government sector. It borrows money from the capital market. It also gets
subsidies from the government sector. It earns income from the exports.
ii. Payment
It includes the factors payments and tax payments to the household sector and
government sector respectively. It makes import payments to the foreign
sector.
3. Government Sector
It has the authority to pass rules and regulation, laviate taxes to the household
sector and business sector, hires factors of production from the household
sector and purchases goods and services from the business sector.
i. Receipts
The major source of the income for the government sector include the taxes
paid by the households and business sectors. It also receives interests and
dividends for the investments paid.
ii. Payment
It pays to the business sector in the return for the goods and services
purchased and also provides subsidies. It pays factor payments to the
household and also makes transfer payments to the household.
4. Foreign Sector
I. Receipts
 It receives income from the business sector in return for goods and services
imported by later.
ii. Payment
It needs to make payment to the business sector from where imports have
been made.
National Income
It refers to the total income of the citizens of a country whether earned within
the geographical boundary of the country or abroad for a certain period of
time period usually 1 year. In brief it is the aggregate of all:
a) Wages and salaries including supplements without deducting taxes and
social security contributions.
b) Net income from the rent and royalties.
c) Income from interest in profits before deducting income taxes
d) Gross profit before deducting income taxes
Concepts of National Income
Concepts of Definition Formula
National Income

1. Gross Domestic It is total market value of all currently GDPt = p1 t . x 1 t + p2 t . x 2t + p 3 t . x 3 t +…+ p nt

Product (GDP) produced final goods and services withing p = price of the goods and
the geography boundary of a country during services
the fixed period of time generally a year. In x = quantity of the goods and
order to be included in the goods and services
services must be:
a. Must be produced currently that year.
b. Must be final goods not intermediate
goods.
c. Currently produced capital goods and
inventories.
d. Must be evaluated in the market price
2. Gross National It is the total annual value of goods and GNP= GDP + NFIA
Product (GNP) services produced by the domestically NFIA= Net factor income from
owned factors of production. It comprises abroad
the income earned by the nationals in the
foreign countries but doesn't consider
 domestically earned income by foreigners.
3. Net National It is the net output of the economy that is NNP= GNP- D
Product (NNP) calculated after deducting the value of D= Depreciation
depreciation from the GNP
4. Net National at It is the sum of all incomes earned by the NI= NNP- Indirect
factor cost or resource suppliers for the contribution of taxes+Subsidies.
National Income their factor resources which go into the
(NI) annual net of production.
5. Personal It is the measure of the income received by PI= NI-Undistributed Corporate
Income (PI) citizens of a country from all sources in a Profit-Corporate Income Taxes-
year. Social Security
Taxes/Contribution+ Transfer
Payments+ Net interest on
public debt
6. Disposable It is the actual amount received by an DI= PI-Direct taxes
Income (DI) individual after the deduction of the direct DI= Consumption (C)+ Saving
taxes that the individuals are liable to pay to (S)
the government. It can also be concluded as
the actual income that individuals can spend
for consumption and saving.
7. Per Capita It refers to the average earning of an Per Capita Income= National
Income individual in a particular region. It helps to Income of a Country÷ Total
determine the standard of living of the Population of the Country
countries.

Relationship between GDP, GNP, NNP, NI, PI and DI

1. GDP= C+I+G+(X-M)
2. GNP= GDP+ NFIA
3. NNP= GNP- Depreciation
4. NI= NNP- Indirect taxes+ subsidies
5. PI= NI- Undistributed Corporate Profits-Corporate tax- Social Security
tax+ Transfer payments from government+ net interest on public debt
6. DI= PI- direct tax
Methods of Measuring National Income
i. Expenditure Approach
It looks at the demand for output and speaks of the components of the
aggregate demand and services. In an open economy, total demand for goods
and services is made up of 4 components:
a. Consumption Expenditure (C)
b. Investment Expenditure.
c. Government Expenditure
d. Net Exports/ Foreign Demands
According to this approach, the GDP can be computed as:
Y=C+I+G+(X-M)
a. Consumption Expenditure
It includes purchase of final goods and services by consumers/ individuals. The
purchase includes purchase of durable goods like stereos, television,
computers, etc, semi/non-durable goods like foodstuff, clothing, petrol, service
like medical care, bus ride.
b. Gross Private Investment
It means addition to or replacement of physical stock of production of capital.
It consists of fixed, inventory and residential investment.
i. Fixed Investment: It includes purchase of new factories, tools and machines.
ii. Inventory Investment: It includes goods that business put aside in storage.
iii. Residential Investment: It includes the new housing of the people buy to live
in.
c. Government Purchases
It includes spending on the wages of civil servants and soldiers, purchase of
computers, tanks, military craft and investment programmes in roads and
hospitals.
d. Net Exports
It is the difference between the value of exports and value of imports. The
export includes expenditure made by foreigners on goods and services of a
country exported to other countries. The import includes the expenditure
made by household, firm and government of a country on imported goods and
services.
ii. Income Approach
It measures the GDP from a flow-cost- approach. It measures GDP by adding
together all the incomes received by suppliers of factors of production over a
fixed period of time normally in one year. Under this method, income
comprises of:
1. Rental Income
It includes all rents received by household for lease of land and other property.
2. Labor income
It includes wages and salaries, commissions, payments in kinds, incentive
payments, tips and benefit.
3. Income from Self-Employment
It covers income of those people who are earning a living by selling their
services or output but are not employed.
4. Proprietor's income
It includes rental income, labor income and income earned from interest and
profits.
5. Interest Payments
It is the payment made to the owner of capital.
6. Corporate Profits
It is the net income of the business after all other costs such as rent, wage and
interest have been deducted from the total income.
7. Indirect Business Tax
It includes sales tax, VAT, excise duty and property tax.
8. Capital Consumption or Depreciation
It refers to the reduction in the value of assets generally from the wear and
tear of the machine.
9. Net Income from Abroad
It is the difference between income earned by the domestic factors of
production in foreign territories and foreign factors of production in the home
country.
iii. Production Approach
It is also known as inventory or output approach. It is done through 2 methods:
a. Final Product Approach
In this method, national income is computed by adding together the market
value of all final goods and services produced by the different industries in a
country within the given year.
b. Value Added Approach
It estimates national income by considering the values of both intermediate
and final output simultaneously. It simply measures how much each firm adds
to the value of an intermediate goods as it moves through the chain of
production.
Importance of National Income:
1. Increase in the national income causes an increase in the material
well-being of the country.
2. It gives an idea to understand the living standard of the people.
3. It provides the data which government and external agencies can
use in different ways.
4. Policy makers use GDP/GNP to monitor short-terms fluctuations in
economic activities and observe long-run growth trends.
5. It helps in assessing the pace of economic development.
6. It gives an regular estimate of an economy's gross output.
7. It is useful for diagnosing economic ills of a country and suggesting
remedies.
8. It enables to assess intra-sector growth of an economy.
Difficulties in the Measurement of National Income:
a. Statistical Difficulties
i. Unrealistic and Inadequate Statistics
It is difficult to obtain data due to the illiteracy in developing and
underdeveloped countries. No proper accounts are maintained for production
and expenditure. Beside this, producers also provide fabricate data in order to
evade from tax.
ii. Existence of Barter System
Even in the era, barter system continues to exist in the backward communities.
No transcations are carried out in monetary terms in barter economy. Under
this circumstances, a correct estimation of NI is impossible.
iii. Underground Economy
It includes illegal activities like gambling, smuggling, drugs, etc. These activities
are not reported to the authority for the tax purpose and are excluded from NI
account.
iv. Self-Consumed Production
Economies in developing countries are involved in producing goods and
services for self-consumption rather for commercial purpose. Some parts of
the produced goods are either consumed by the producer themselves or
bartered for some other goods with consumers or other entities in the market
which makes it difficult to calculate NI.
v. Lack of Occupational Classification
People under developed countries engage themselves in one or more
occupations to earn their livelihood. There is no clear cut classification of
occupations and it is very difficult to identify the incomes of the individuals
from specific job or other occupational undertaking.
b. Conceptual Difficulties
i. Problem of Definition
The major problem arises when defining the composition of NI. Ideally NI
includes all the goods and services produced within the certain time period but
there are times when it is difficult to decide which goods to include and which
goods to exclude.
ii. Price Changes
Change in price is the greatest challenge in computing national income. The
continuous change in the raw material, production process and finished goods
make it difficult to get determined the actual cost of the good and services
when they arrive at the market.
iii. Double Counting
It is one of the issues arise when determining national income. The problem of
inaccuracy is seen when the value of NI is inflated due to the double counting
so only the value of final goods must be taken into considerations.
iv. Income from foreign investors
The problem arises especially with countries where MNC reside. Although
MNC are doing well in the host country, a part of their total income goes to the
mother company located in a foreign land So the actual NI of a host country for
the current year cannot be accurate determined.
v. Environmental Damage
It is caused by the depletion of natural resources, pollution and the reduction
in the mineral resources. NI accounting neither prepare the account of natural
resources depletion nor measures the impact of environmental damage in
human healthy condition.
Say's Law of Market
Introduction
It is core of the classical theory of employment. Say's law of market is named
after Jean Baptiste Say which states that supply creates its own demand. This
law states that aggregate output produces aggregate demand of same level
and argues that prices and wages are flexible maintaining an equilibrium state
in self-regulating economy.
Assumptions:
a) Wage and price are flexible in labor and goods market.
b) There is perfect competition in those markets.
c) There exists full employment in the economy.
d) Money is only medium of exchange.
e) Capital stock and technology of production are given.
f) Total output of the economy is divided into consumption and saving.
g) It assumes long run.
h) There existence of full employment without inflation.
i) There is laissez-faire capitalist economy.
Say's Law in a Barter Economy
Say's law was first explained in barter economy and operates logically for
barter economy. In barter economy, goods are produced for either self-
consumption or direct exchange to get some other goods. To supply one good
in barter economy is necessarily to demand another. Hence, every seller is a
buyer.
Say's Law in a Money Economy
This law remains valid even in the money economy because classical
economists view money only as the medium of exchange with no active role in
influencing the real sector of the economy. In money economy, the purchase
and sales of good is made possible only by money.
Keynes Psychological Law of Consumption
Introduction:
This theory is propounded by J .M Keynes. It explains the relationship between
change in income and corresponding change in consumption and saving.
According to this theory, when the income increases consumption also
increases less than increase in income because few part of the income is spent
on saving.
Assumption:
1. Psychological and Institutional factors like taste and preference, fashion,
price level, population, etc. are constant.
2. There is existence of normal condition which means no war, conflict and
hyperinflation.
3. There must be no government intervention.
Income in million Consumption in million Saving in million
0 40 -40
200 200 0
300 280 20
400 360 40
500 444 60
 C=Y

Consumption

Saving

C=a+bY

Consumption
a

Income (Y)

Fig: Keyne's Psychological Law of Consmption