4 | CIRCULAR FLOW OF INCOME oem LEARNING OBJECTIVES 4.1 INTRODUCTION 1.2 MEANING OF CIRCULAR FLOW OF INCOME : 1.3 STOCK AND FLOW 1.4 TYPES OF CIRCULAR FLOW 1.5 CIRCULAR FLOW IN A SIMPLE ECONOMY (TWO-SECTOR ECONOMY) 4.1 INTRODUCTION on a a a th The unlimited and recurring wants of human beings production continuous process. In this process, En par eae ° ; different factors of production: Land, Labour, Capital and Enterprise are combined ion of goods and services. . ices with collective efforts of factors of production supplis by the house ng » Firm ent to the factors of production in the form of rent, wages, interest and profit (known as factor incomes). 7 i re + The household sector spends this money on the purchase of goods and services produced by the firms teers 1.2 MEANING OF CIRCULAR FLOW OF INCOME It refers to cycle of generation of income in the production process, its distribution among the factors of production and. its lation from households to firms in the form of iponsumption expenditure on goods and services'produced by them. Phases of Circular Flow of Income There are 3 different phases (generatic istribution and dis] ion) in circular flow of income, epee i at1. Generation Phase: In this phase, firms produce goods and services with the help of factor services. #2. Distribution Phase: This phase involves the flow of factor income (rent, wages, interest and profit) from firms to the households. 3. Disposition Phase: In this phase, the income received by factors of production, is spent on the goods and services produced by firms. In this way, incomié generated in production units reaches back to production units and makes the circular flow complete. i 1.3 STOCK AND FLOW er ee nk The concepts of stock and flow are used frequently in macroeconomics. Some of the macro variables relate to stock, while others relate to flow. Therefore, it is important to understand their meaning so that variables can be categorised as stock or flow. Stock Stock variable refers to that variable, which is measured at a particular point of time. >, example, stock of goods in the godown as on 31°* January, 2019. It means, stock variables are not fie diese oro ean of stock variables are National wealth, National capital, time dimensional. Some more examples of stock variables are Nation ae Flow Flow variable eee to that variable, which is measured over a period of time. For exam fi month of January ‘2019, birth rate in the year 2018, National | is the quantity of water in On the other hand, water tap is a flow of water being time. ‘on December 31, 2018 is the er of houses constructedGiroular Flow of Income 13 Difference between Stock and Flow a ae Meaning Stock variable refers to that variable, | Flow variable refers to that variable, which is measured al @.particular point | which is measured over a period of ottime, tine. Time Itdoes not have atime dimension, | It has a time dimension as its Dimension magnitude can be measured over a Period of time. Nature of | Itis a static concept. Itis a dynamic concept. concept Examples: 1. Population of India as on 31.03.18. | 1. Number of births during 2018. 2. Total number of Maruti cars in Delhi. | 2. Maruti cars manufactured during "January, 2019. 3. Money supply (money in circulation). |3, Expenditure-or transactions in t money. 4. National Wealth. 4. National Income. 5. Quantity of wheat stored. 5. Quantity of wheat produced. 4.4 TYPES OF CIRCULAR FLOW - There are two types of circular flows: (i) Real flow; (ji) Money Flow. Real Flow Real flow refers to the flow of factor services from households to firms and the corresponding flow of goods and services from firms to households. _ ‘Asseenin the diagram, households provide factor services mecca to the firms which, in turn, provide goods and services to (Land, Labour, Captal and coat them as a reward for their productive services. (Camas) te « Ibis also known as ‘Physical flow’ i © There is only exchange of goods and services between Goods and Services the two sectors without involvement of any money. Fig. 1.2 © Real flow determines the magnitude of growth process in an economy. For exainple, when. more factor services are offered to firms, then polume of production will be more and it speeds up the process of economic growth. Fi Money Flow Flow. frst io escholay or ql Gormmtn dit ee (On Goods and Services) Y Households } aaa fnator Payments — income on ogo servis pce ys woe ti firms. * Itis as ‘Nominal flow’. © Tein of money between the two sectors. (414 Introductory Macroeconomics Difference between Real Flow and Money Flow Itis the flow of money between firms and households. Itinvolves exchange of money. It is the flow of goods and services between firms and households. It involves exchange of goods an services. | Meaning | {Kind of exchange Difficulty in There may be difficulties of barter system | exchange in exchange of goods and factor services, *¥ Alternative Name | It is also known as Physical Flow. There is no such difficulty in case! of money flow. Itis also known as Nominal Flow. Four Sectors of the Economy The four major sectors in an economy according to the macroeconomic point of view are: 1. Household Secigx It includes consumers of goods and services and also the owners of factors of production. They supply factors like land, labour, capital and entrepreneur anq receive income in return in the form of rent, wages, interest and profit respectively. 2. Producing Sector It includes all producing firms in the economy. To produce ae hires factors of production from the households. Households consume goods and services to satisfy their wants and firms produce goods and services to make a profit. 3. Governmy _Itacts in two capacities: = re aj it is involved in maintaining law and order, defence and other ‘Services of public welfare. — | « Asa producer, it produces and services in public sector enterprises. 4 Bo ecto he World Sector): This sector includes of the eri Tt is cSETSE in export and import of goods and dow flow of capital between the domestic economy and other countries of the world. 1.5 CIRCULAR FLOW IN A SIMPLE ECONOMY (TWO-SECTOR ECONOMY) ____ A simple economy assumes the existence of only two sectors, i.e. household sector and firm firm ‘sector. * Households are the owners of factors of production and consumers of goods and services. + Firms produce goods and services and sell them to the houscholds. Itis the simplest form of closed economy", in which there is no government sector and foreign trade. any country which does not have any: hhas 3 sectors: Household Sector, any Foreign Sector.Circular Flow of income 15 Inorder to make our analysis simple, we take some assumptions: 1, There are only 2 sectors in the economy; Households and Firms, It means, there is no government and foreign sector. 2. Household sector supplies factor services only to firms and the firms hire factor services only from households. 3. Firms produce goods and services and sell their entire output to the households. Households receive factor income for their services and spend the entire amount on consumption of goods and services. - There are no savings in the economy, i.e. neither the households save from their incomes, nor the firms save from, their profits. The Circular flow in Two-Sector economy can be better understood with the help of Fig. 14. * The outer loop of diagram shows the real flow, i.e. flow of factor services from households to firms and corresponding flow of goods and services from firms to households. Theinner loop shows the money flow, ie. flow of factor payments from firms to households and the corresponding flow of consumption expenditure from households to firms. In the circular flow of income, production generates factor income, which is converted into ‘expenditure. This flow of income continues as production is a continuous activity due to never- ending human wants. It makes the flow of income circular. Conclusions of Circular Flow in a Simple Economy awn: Consumption of goods and