CA Rahul Khatri 12th Economics

Chapter 3: Circle of income Flow

Overview of this chapter

Overview

Stock Meaning of Circular Phases and Types of Models of Circular Leakages and injections in
and Flow flow of Income Circular flow of Income Flow of Income the circular flow of Income

Stock and Flow

Stock Variables: Flow Variables:

Variable whose quantity is Variable whose quantity is calculated for
calculated at a fixed date ( say 31st some time period ( say from 1st April to
March ) or at a specified date is 31st March ) or for a day, a month ,
called Stock Variable quarter etc. is called Flow Variable

Examples of Stock Variable

Examples of Flow variables
 Money Supply
 Income from Investment
 Capital
 Income
 Wealth
 Profits
 Foreign Debts
 Saving
 Inventories
 Production
 Bank Balance
 Exports

Inter Relation Between Stock and Flow Variables

 By Using Stock Variable, we can generate flow variables like : Bank balance is Stock Variable but
using bank balance in production and other activities we can generate flow Income. So both are
Related to each other.
 In similar way Flow income can affect Stock variables like : Profit is flow variable but we can use
profit in purchasing inventories or we can make reserves both are stock variable so in this way we
can say that flow variable affects Stock variable

Note : price is not a stock variable or not a flow variable

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CA Rahul Khatri 12th Economics

Meaning of Circular flow of Income

 Every person in economy are doing some activities or transactions like : Doing job, Production,
giving service and due to these transaction’s and activities money flow from one hand to
another and this generates income and Expenses. This is called circular flow of Income.
 Classification of Economy as per circular flow of Income

Production and Service Sector Production Activities or giving Service

Household Sector Consumption
Government Tax , Subsidies and other
Financial Exports and imports
Rest of the World ( Foreign ) Saving and Investments

Phases and Types of Circular flow of Income

a. Phases
Production/ In this Phase, production of goods or service is carried out
Generation phase
Income Phase/ In this phase producer/owner creates Income by selling their products in
Distribution Market
Expenditure / Income generated by the producer is expend in purchasing other goods or
Disposition Phase services for their need.
Production Phase

Expenditure Phase Income Phase

b. Types
o Real Flow/Product Flow/ Physical Flow :Households provides various types of services
to business entity so that business can make their product after making it business
supply it in market and household use these product or service. This flow of income is
called real flow

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CA Rahul Khatri 12th Economics

(2) Provide Labour, Land, Capital Business

Household Entity
(1) Goods and Services

o Money Flow/Nominal flow/Income Flow :As we know that household provides various
services to business entity and for this business entity pay to the household.
On the other hand business entity supply various goods and services to household and
they paid money for this. This circular of money is called money flow.

Business pay moneyfor services provided by Households Business

Household Entity
Business receives money for their goods and services

Model of Circular flow of Income

 Two Sector economy without saving ( Simple Economy )

 Two Sector economy with Saving ( Economy with Financial institutions)
 Three Sector economy ( Economy with government )
 Four Sector economy ( Economy with foreign transactions )

Two Sector economy without saving ( Simple Economy )

o In this economy, there are only 2 sectors, first is Households and second is business
entities. Households provides various services to business entity and business entity
provides goods and services to household and due to this flow of income created
o One thing should remember, in this model households does not have habit of saving

House Business
hold entity

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CA Rahul Khatri 12th Economics

Two Sector economy with Saving ( Economy with Financial institutions)

 Household do not use their compete money. It is simple and practical, they save some part of
their earning.
 So for the purpose of saving they can open saving bank account and can deposit some part of
their earning.
 For this purpose various financial institutions are working
 Normally financial institutions are intermediators between savers and investors
 So in this Two Sector economy, household saves some part of their earning.

House Business
hold entity
Banks,
Financial

Three Sector economy ( Economy with government )

 It is more realistic and useful model.
 In this model government comes in the picture.
 As we know that government provides various types of financial assistance to the public and
business units and also government can purchase goods and services from business entity and
can take services from households so for this government make payment.
 We also know that government takes taxes and various types of penalties and other from the
business entities and households so in this way government receives money.
 So in this way we can say that government has very important role in the economy.
 So a money/ income flow model where households(with saving ), business entities ( with
savings ) and government comes to in picture is called Three sector economy.

 So in this Two Sector economy, household saves some part of their earning.

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CA Rahul Khatri 12th Economics

House Banks, Business

hold Financial entity

Four Sector economy ( Economy with foreign transactions )

 This model is also called “ Open Economy model”
 As we know that there can be International transactions also in an economy. Simply we call it
Foreign transaction ( Import – Export ).
 Firms can purchase outside from the country ( Import ) and also firm can sale goods to outside
the country ( Export ).
 Household can also purchase goods and services from outside country.
 So an economy where International transactions are happened is called Four Sector economy.
 In this economy there are : Business entities , Households , Government and foreign
transactions (Rest of World )

If Import > then Export Level of National income will go

Ex: Import = 1,00,000 Cr.
Export = 85,000 Cr.
down
Level of National income will rise
If Import < then Export
Ex: Import = 1,00,000 Cr.
Export = 85,000 Cr

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CA Rahul Khatri 12th Economics

House Business
hold entity

Leakages and injections in the circular flow of Income

Leakage : When Money are withdrawal from
the economy then it is called Leakage.
In Simple wording Leakage means outflow of
money from circular flow.
It creates Negative Impact In the
economy
Example : Savings , Taxes , Import from
Outside etc.
Injection : When more money are put inside
the economy then it is called Injection.
In Simple wording Injection means Inflow of
more money in the circular flow.
It creates positive Impact In the
economy
Example : Investment , Export , Government
assistance and grants

 Saving : Money saved by household is withdrawal of money from circular so it is leakage of

Income But it this money is deposited in the bank account then it can be funded by the banks
and borrower can make investment in the economy so for this way if money is deposited then it
is injection of money in the economy
Money hold by house hold and not deposited If money hold by the household is deposited
in Bank = Leakage in bank = Injection

 Taxes: Business will have to pay tax on the profit generated by the business. This taxed money is
not used in production activities by the business so it is Leakage in the circular flow

 Import from Outside :If business entities and households Import from outside then they have to
make payment and in this way money will go out from circular flow so it creates leakage .

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CA Rahul Khatri 12th Economics

 Investment : Due to new investment in the business and other way money is came in the
circular flow so it is injection.

 Export :Due to Export, foreign currency came in the circular flow and it creates injection in the
economy.

 Government assistance and grants : Government provides grants like : subsidies and various
types of assistance due to this money came in the circular flow and it is injection

Other Parts of the Chapter

Difference between Stock and Flow

Stock Flow
Economic variable which is measured at a Economic variable which is measured for a fixed
particulars point of time. time period
At a fixed time ( no time dimension ) For some time period ( it has time dimension like
per hr. , per week, per month , per year etc. )
Static Concept Dynamic Concept dcxw

Difference between Real flow and Money Flow

Real Flow Money Flow
Flow of goods and service between business entity Flow of Money between business entity and
and households households
It is also know as physical flow and product flow It is also know as Nominal flow and Income Flow
It is like barter exchange It is related to money.

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