THE CIRCULAR FLOW OF INCOME

The operation of various financial forces in an economy can be expressed in the form of a circular flow of income and spending between
households and firms.

The Circular Flows in a basic Two-Sector Model

In the accompanying diagram, the upper half represents the factor market and the lower half represents the product market.
Both the markets generate two kinds of flows viz. Real flows and Money flows, which move in opposite directions.

In the upper half, the arrow labelled FOP shows the flow of factors of
production from the households to the firms. The real or factor flow causes
another and a reverse flow, that is, the flow of factor incomes (wages,
interest, rent and profits) from the firms to the households. Since all factor
payments are made in terms of money, the flow of factor incomes
represents the money flow, which comprises the total income of the
households. In the lower half, the goods and services produced by the firms
flow to the households, representing the real flow. Correspondingly, the
payment made by the households to the firms for the goods and services
creates the money flow. When we combine the real and money flows in the
factors and product markets and look at the flows in continuity, we observe
an evident circularity in the flows.

The Two-Sector Model with Savings

We assume that all savings are made by the households and extend the
two-sector model to include the financial sector, or the capital market,
which is constituted of a large variety of institutions involved in collecting
household savings (S) and passing it onto the business sector for
investments (I). The circular flow of income and expenditure in a two-
sector model with capital market is shown in the accompanying diagram.
With the inclusion of the financial sector, the household income Y gets
divided into two parts viz. Consumption expenditure (C) and savings (S),
both ultimately reaching the business sector via different routes, the former
directly, and the latter routed through the financial sector.

Circular Flows with Government: A Three-Sector Model

This requires adding and analysing the effects of government's fiscal operations
viz. collection of taxes, spending on goods and services and transfer payments
etc. Taxes are withdrawal from the flows since they reduce private disposable
income and, therefore, consumption expenditure and savings. On the other
hand, government expenditure is an injection into the income stream. The
transfer payments by the government (e.g. old age pensions, subsidies,
unemployment allowance etc.) are injections to the circular flows. The circular
flows of income and expenditure in a three-sector model are shown in the
accompanying diagram. As the figure shows, a part of the household income is
claimed by the government in the form of direct taxes. Similarly, a part of the
firm's earnings is taxed away in the form of corporate income tax. The
government imposes indirect taxes also which are collected by the firms from
the households and passed on to the government. The government spends a part
of its tax revenue 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 households and the firms of the government in the
form of taxes, flows back to these sectors in the form of government
expenditure.
Circular Flows with Foreign Sector: A Four-Sector Model
The foreign sector consists of two kinds of international transactions: (i) foreign trade, i.e. import and export of goods and services, and
(ii) inflow and outflow of capital. For the sake of simplicity, we make the following assumptions.
(i) The external sector consists only of exports and imports of goods and services;
(ii) The export and import of goods and non-labour services are made only by the firms; and
(iii) The households export only labour.
The circular flows of income and expenditure in a four-sector model is
illustrated in the accompanying diagram. It is to be noted that this figure shows
only the money flows; each money flow has its counterpart goods flow in the
opposite direction. The lower part of this figure shows circular flows of money
in respect of foreign trade. Exports (X) make goods and services flow out of
the country and make money (foreign exchange) flow into the country in the
form receipts from export. Similarly, imports (M) make inflow of goods and
services and flow of money (foreign exchange) out of the country. Another
inflow of income is generated by the 'export of manpower' by the households,
which brings in 'foreign remittances' in terms of foreign exchange. These
inflows and outflows go on continuously so long as there is foreign trade and
export of manpower. So far as the effect of foreign trade on the magnitude of
the overall circular flows is concerned, it depends on the trade balance, which
equals X-M. If X>M, it means inflow of foreign income is greater than the
outflow of income, or there is a net gain from foreign trade. If X<M, it means
inflow of foreign income is less than the outflow, resulting in a net deficit
from foreign trade.
INJECTIONS AND WITHDRAWALS

A. Injections into the Circular Flow of Income (Two-sector Model)

If income received from any source outside the circular flow of income enters into the flow, then it is called injection.

Sources of Injection into the Circular Flow of Income

a) Injection through Additional Investment: Firms take loan from commercial banks or other financial institutions for additional
investment. Since the money is not coming from the households, this represents an injection. Further firms which produce capital
goods earn income by selling them which is also not coming from the households, but from other firms. This is also an injection
into the circular flow.
b) Injection through Export: If the country engages in foreign trade, exporting firms earn income by selling goods and services to
foreign country. The total money value of export of the country is an injection into its circular flow of income.
c) Injection through Government Expenditure: The most important government expenditures which can inject into the circular flow
of income are as follows:
 Government Purchase of Services from the Households: For example, income of the government servant received by giving
services to the government is not coming from the firms. So this is an injection into the circular flow of income.
 Government Purchase of Commodities from the Firm: Income received by the firms by selling commodities to the
Government is not coming from the households. So this is also an injection into the circular flow of income.
 Transfer Payments: Money received by the public without giving any return to the government is called transfer payment, e.g.
expenditure on old age pension, widow pension, unemployment relief etc. This income or transfer payment is not coming from
the firms and hence is an injection into the circular flow of income.
 Subsidies: Sometimes the government gives subsidy to the week and sick industrial units. The amount of money received by the
firms is not coming from the households, and hence is an injection into the circular flow of income.

Therefore the total amount of Injection (J) into the circular flow of income of a country is the sum of the amount of injections
through Additional Investment (I), Export (X) and Government Expenditure (G). Thus, J = I + X + G.

B. Withdrawals from the Circular Flow of Income (Two-sector Model)

That part of income which is extracted from the circular flow of income but does not reach the firms or households represents withdrawal
from the flow.

Sources of withdrawal from the Circular Flow of Income

a) Withdrawal through Savings: A part of the disposable income of the households is saved i.e. not spent for purchasing goods and
services. Similarly, business firms keep a part of their income in the shape of undistributed profit or reserve which is not distributed
among the owners. Both these represent withdrawals from the circular flow of income. If savings are subsequently converted into
investments, then such savings again enter the circular flow.
b) Withdrawal through Import: If the country engages in foreign trade, then households, firms or government of the country may
import goods and services. The amount spent on imports represents a withdrawal. In the same manner, if firms use foreign labour or
other foreign factors, then the amount of money given to the foreigners do not come back to the households as income. So this is also
a withdrawal.
c) Withdrawal through Tax: Government collects direct tax (e.g. income tax, wealth tax) and indirect tax (e.g. goods and services tax)
from the households and firms. Both these types represent withdrawals from the circular flow of income, since these are spent by
either households or firms, but do not come back to the other.

Thus, total amount of Withdrawal (W) from the circular flow of income of a country is the sum of the amount of withdrawal
through Savings (S), Import (M) and Tax (T). W = S + M + T.

Equilibrium in the Circular Flow of Income

In any country if the total amount of withdrawals from the circular flow of income is equal to the total amount of injection into the
circular flow, then equilibrium in the circular flow of income is said to be established. Thus, the equilibrium condition of the circular flow
of income is Total amount of Injection (J) = Total amount of Withdrawal (W)

i.e. J = W or, I + X + G = S + M + T

This condition will be satisfied if S = I, X = M, G = T.

This means that if total savings (S) and total investment (I) of the country are equal to each other, if the value of total export (X) and of
total imports (M) of the country are equal to each other and if government expenditure (G) and government income (T) of the country are
equal to each other, then equilibrium in the circular flow of income is established.