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 UNIT: IV

Circular Flow of Income

• Two Sector model

• Three sector model

• Four Sector model

 Learning Outcome

• How the circular flow takes place?

• Knowledge about what are the injections

and leakages in the economy.
 Let’s recall

1. Differentiate between internal and

external environment that affects the
decision making of business.
Circular Flow of Income
The simple model of the circular flow assumes two players:

1. Firms

2. Households

Firms

• Produce and supply the goods and services.

• Require various factors of production to produce these goods

and services.
Households

• Include a set of individuals living in the same house

• Provide services in terms of factor inputs to the firms

• Get paid for these services by firms which households spend on

consumption.

• Money flows from firms to households as factor payments and from

households to firms as expenditure on goods and services.

• It is a circular flow of money or income

• Money flow and real flow are the two main
aspects of the circular flow of income
economic model.

• Real flows refer to the flow of the actual

goods or services, while money flows refer
to the payments for the services (wages, for
example) or consumption payments.
 Circular Flow of Income
(Two Sector Economy)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)
Factor Inputs

Financial
Households Savings Market Investment Firms
(S) (I)

Goods and
Services (O)

Consumption
expenditure
(C)
Circular Flow in Three Sector
Economy
• In three-sector economy there are three
parties:

a) Household

b) Firms

c) Government
Here, there are two important components:

a. Injection: Injections are types of

expenditure on goods and services that
have any origin other than the household
consumption.
 Can you give examples of
injections into the economy?
1. Government purchases

2. Transfer payments

3. Investment
b. Leakage: Instead of spending all of the
income immediately on consumption, part of
household income “leaks out” from the
economy, which is called leakage.
 Can you give examples of
leakages into the economy?
1. Savings

2. Taxes

3. Investment
Polling question
Closed economy is an economy where:

a. There exists trade relations with rest of

the world.
b. There do not exist any trade relations with
rest of the world.
c. Both (a) and (b).

d. None of the above.

Circular Flow in Four Sector
Economy
• The circular flow model in four sector
economy provides a realistic picture of the
circular flow in an economy.
• The four sector economy comprises of:
a)Household

b)Firms

c)Government

d)Foreign Sector
 Circular Flow of Income
(Four Sector Economy)
Government
(G)
Taxes
Taxes
Factor
Payments Remittances
for purchases
Factor Inputs
Salaries

Savings
(S) Financial Market Firms
Households Investment
(I)
Imports Imports
Goods (M)
(M) (O)
Consumption
Expenditure

Foreign Nations Exports

Exports (X-M) (X)
(X)
National Income=C+I+G+(X-M)
 Injections and Leakages from
Circular Flow
Injections Leakages
• Savings • Investment

• Taxes • Government Spending

• Imports • Exports
Polling question
Savings and imports constitute ________
to/from the circular flow:

a. injections
b. leakages
c. Both (a) and (b)

d. None of the above