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ECONOMICS FOR EVERYONE – CIRCULAR FLOW - Basic Framework Of An

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Prof.M.Guruprasad CIRCULAR FLOW ECONOMICS FOR EVERYONE

ECONOMICS FOR EVERYONE – CIRCULAR FLOW - Basic Framework Of

An Economy

Prof.M.Guruprasad, AICAR BUSINESS SCHOOL

How does the Economy Work?

How does the overall economy work? How do we analyse the macro and micro economic
issues. This is the most frequently thought about question in our mind whenever there is
any debate on some economic issue affecting the nation. Often, people wish to
understand the working of the economy, but could not make meaning out of it and many
other economic issues. This is due to the reason that the debates, writings and any
discussions on economy and economic issues assume that the reader knows and
understands the basic working of the economy. The truth is even educated citizen could
not comprehend the logic of the subject, since many people perceive the subject of
economics to be abstract and complex.

Let us understand the basic simplified working of the overall macroeconomic system and
the micro parts

The fundamental decision making units in a market economy are firms and househo lds.
A firm is an entity that produces goods or services. Firms take resources (like labour,
capital, and other inputs also known as the factors of production) and transform them
into products that people or other firms wish to purchase.

Example:

Of a firm would be an automobile producer that takes labour, tires, sheet metal,
machinery, and other inputs and transforms them into cars and trucks. Firms are the
primary producing units in a market economy. Each firm started out as the dream of one
or a few individuals. People who are responsible for taking new ideas or new products
and turning those ideas into successful businesses are known as entrepreneurs.
Entrepreneurs are also often responsible for organizing, managing, and assuming the
risks of a firm.

As discussed, firms and households form the other fundamental component of market
economies. Households can range from individuals living alone and single -parent families
to college friends sharing a house as well as extended families living together.
Households are described in the text as the primary consuming units in an economy.

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Prof.M.Guruprasad CIRCULAR FLOW ECONOMICS FOR EVERYONE

The Circular Flow

Input Markets and Output Markets: The Circular Flow –the basic framework of
an economy

Let us look a bit closer at these basic ideas through an illustration. One model
that helps explain how a market economy works is a circular-flow diagram. A
circular-flow diagram is a visual model of the economy that illustrates how
households and businesses interact through markets for products and markets
for resources.

Firms sell the goods and services they produce in product or output markets. The
resources they purchase in order to make their outputs are bought in input (land,
labour, capital, entrepreneurship) or factor markets. Where do firms get their
inputs? From households of course! Think about when you or some other member of
your household goes off to work. Where are you (or they) going? You (or they) are
probably going to a firm!

Household members supply the labour that enables firms to produce their outputs. In
addition, households supply the funds that firms use to purchase land, factories, office
buildings, and equipment. How do they do this? There are two ways. Firstly when
households buy goods, the price they pay is the revenue which the firm can use as it s
funds for the purchase of factors. Again, when members of a household save for the
future by putting money in a bank, or buy stocks or corporate bonds, they are again
supplying the firms with funds to finance such expenditures.

An input market is where t he resources used to produce goods and services are
exchanged. A labour market is the input market in which households supply work for
wages to firms that demand labour. A capital market is the input market in which
households supply their savings to enable firms to buy capital goods. In exchange they
earn interest from the firms who use the capital goods. A land market is the input
market in which households supply land or other real property to firms in exchange for
rent.

It’s obvious that when household members work they are supplying the labour input to
firms. But what about the other things firms use as inputs? For example, what if a firm
uses electricity? Doesn't it buy that from another firm? The answer of course is "yes,"
but remember that the elect ric supplier also demands inputs from households to produce

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Prof.M.Guruprasad CIRCULAR FLOW ECONOMICS FOR EVERYONE

the power that it in turn sells to others. Ultimately, all inputs come from households,
even if they come indirectly through other firms!

In sum each fundamental unit of the economy, whether house hold or firm, acts both as
producer and consumer.

The circular flows of income and expenditure: two sector model

We can see from the illustration that Households supply factors of production to firms
who in exchange provide factor incomes to households for use of these factors. Firms
also provide the households with various types of goods and services that are consumed
by the latter. In turn the firms receive payment for goods and services they sell to the
households. The cycle is complete. The above circular flow can be illustrated through
the factor and product market flow given below
Circular Flows of Income and Expenditure in a F ive-Sector Model

In the above paragraphs we have considered just two sectors – households and
firms, which are present in both the micro and macroeconomic context. Let us now
extend the analysis to t hree more sectors which are critical when we consider the
workings of the macro economy – namely government, the external economy and
the financial institutions in the financial system. The circular flow between these
sectors is illustrated in figure given below. As we can see, the flows between the first
two sectors, namely households and firms, are continued. While firms make factor
payments to the households, the latter engage in consumer expenditure and buys goods
from firms [What happens if they do not spend for consumption? We will answer this
later]. Households also invest their surplus savings in financial institutions [termed as FI

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Prof.M.Guruprasad CIRCULAR FLOW ECONOMICS FOR EVERYONE

s in the figure below]. These institutions are also known as financial intermediaries since
they in turn lend or invest the household savings they have received in equity and debt
securities issued by firms. Insurance companies, both life and general, form part of the
financial institutions sector. They play a vital role in channelizing surplus funds of
households to various productive enterprises. The third sector in this model is
government. It receives its revenues in the form of direct and indirect taxes, from firms
and households. In turn it makes various kinds of factor and transfer payments to
households and also provides funds to firms in the form of subsidies and purchases.
Finally there is the external or foreign sector. With respect to foreign countries, we have
export of manpower [migration] to foreign countries. These non residents in turn make
remittances to the home country, resulting in precious foreign exchange coming in.
Foreign exchange is also earned when a country exports its goods to foreign countries.
On the other hand when a country imports goods from outside, it has to expend its
foreign exchange in paying for these goods. So long as a country earns more foreign
exchange [through exports and inward remittances] than it needs to pay out [for
imports and by way of outward remittances], it can be said to have a favourable
Balance of Payments.

The model discussed below would help us a great deal in understanding the factors in
macroeconomic equilibrium. In general we can say that equilibrium is maintained so long
as the income generated by households or firms is ploughed back into the system in the
form of either consumption or investment expenditure. The problem arises when such
consumption or investment expenditure does not occur – in other words there is a
leakage from the cycle. This situation, which has been termed as shortfall in effective
demand, was diagnosed by Keynes, as the principal cause of the great depress ion. The
principal contribution of Keynes and his followers was to prescribe a spurt in government
spending to make up for shortfalls in private household spending.

The idea was simple. If government could pump money into the system and use it to
make factor payments to households or make purchases from firms, it would help to
stimulate demand [of households and government] for goods made by firms. The latter
in turn would find that their inventory [of unsold goods] is reduced and would have the
incentive to invest more capital and enhance production. In the process, industry would
create more jobs, thus reducing unemployment. During the first half of the twentieth
century and indeed, till the seventies, the writings of the Keynesian economists
significantly influenced policies of many governments. Keynesian economics, for
example, formed the foundation of the “New Deal” programme, which was initiated by
President Franklin Roosevelt, in the thirties, which pulled the USA out of the great

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Prof.M.Guruprasad CIRCULAR FLOW ECONOMICS FOR EVERYONE

depression. Keynesian prescriptions also formed the basis for the policies followed by
welfare state economies of Europe in the post war years. In recent decades,
Keynesianism has been assailed by an opposing strand, known as monetarism.
Championed by Nobel Prize winner, Milton Freidman, it calls for a strict control on
government spending, which results in excessive money being pumped into the system.
Freidman and others, who form part of the Neo Liberal School, argue that markets
should be left alone to usher equilibrium int o the system. According to them, too much
of monetary infusion and corresponding rise in demand could lead to inflation and rising
prices which could destabilize an economy seriously.

Circular Flows of Income and Expenditure in a Four-Sector Model

Government

Financial

Households System (Financial Firms

Intermediaries)

Foreign Sector

The circular flow of economic activity is a model showing the basic economic
relationships within a market economy. It illustrates the balance between injections and
leakages in our economy. Half of the model includes injections, and half of the model
includes leakages. The circular flow model shows where money goes and what it's

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Prof.M.Guruprasad CIRCULAR FLOW ECONOMICS FOR EVERYONE

exchanged for. The model includes households, businesses and governments. We also
have the banking system that facilitates the exchange of money and, as we'll see in a
minute, helps to productively turn savings into investment in order to grow the
economy. In the circular flow of the economy, money is used to purchase goods and
services. Goods and services flow through the economy in one direction while money
flows in the opposite direction. The circular flow of model shows the balance of injections
and leakages. The circular flow of income or circular flow is a model of the economy in
which the major exchanges are represented as flows of money, goods and services, etc.
between economic agents. The flows of money and goods exchanges in a closed circuit
and correspond in value, but run in the opposite direction. The circular flow analysis is
the basis of national accounts and hence of macroeconomics.

In essence as discussed above, t he factors of production include land, labour, capital

and entrepreneurship. The prices that correspond to these factors of production are rent,
wages and profit. People in households buy goods and services from businesses in an
attempt to satisfy their unlimited needs and wants. Households also sell their labo ur,
land and capital in exchange for income that they use to buy goods and services that
firms produce. Businesses sell goods and services to households, earning revenue and
generating profits. Businesses also pay wages, interest and profits to households in
return for the use of their factors of production. Governments levy taxes on households
and businesses in order to provide certain benefits to every one. Financial intermediaries
play the key role of transferring the financial resources, capital from
surplus(Savers,investors,lenders) units/components of any sector of the circular flow
(that is the economy of a nation) to the deficit units( those who require it). Finally,
Households, Firms, governments, Financial system of the circular flow (hence any
economy of a nation) connected globally through the foreign sector (External sector).

Injections and Leakages

Let us now discuss about injections and leakages. When you look at the circular flow
model more closely, you find that there are things that inject money into the economy
and other things that leak out of the economy. Injections into the economy include

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Prof.M.Guruprasad CIRCULAR FLOW ECONOMICS FOR EVERYONE

investment, government purchases and exports while leakages include savings, taxes
and imports.

Savings leaks out to borrowers as it goes through the banking system, and borrowers
use the money to buy goods and services, which then injects the money back into the
circular flow. Government taxes leak out of the circular flow model, and then
government spending injects them back into the economy. Imports leak out of the
economy because the money in our country that's used to buy imports from other
countries goes out of our economy and into their hands. Exports, on the other hand, are
an injection because we earn income from the goods and services we export to other
countries.

The idea of the circular flow was already present in the work of economist Richard
Cantillon. François Quesnay (French economist of the Physiocratic school) developed
and visualized this concept in the Tableau économique.Nobel laureate Richard Stone
further developed the concept for the United Nations (UN) and the Organisation for
Economic Co-operation and Development to the system, which is now used
internationally.

Production, consumption expenditure and generation of income are the three basic
economic activities of an economy that go on endlessly and are titled as circular flow of
income. Production gives rise to income, income gives rise to demand for goods and
services; such a demand gives rise to expenditure and expenditure induces for further
production. The whole process forms the basis for circular flow of income and related
activities- production, income and expenditure are known as phases or stages of circular
flow of income.

Significance of study of circular flow of income

1. Measurement of National Income - National income is an estimation of

aggregation of any of economic activity of the circular flow. It is either the income of all
the factors of production or the expenditure of various sectors of economy. However,
aggregate amount of each of the activity is identical to each other.

2. Knowledge of Interdependence - Circular flow of income signifies the

interdependence of each of activity upon one another. If there is no consumption, there
will be no demand and expenditure which in fact restricts the amount of production and
income.

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 Prof.M.Guruprasad CIRCULAR FLOW ECONOMICS FOR EVERYONE

3. Unending Nature of Economic Activities - It signifies that production, income and

expenditure are of unending nature, therefore, economic activities in an economy can
never come to a halt. National income is also bound to rise in future.

4. Injections and Leakages

Prof.M.Guruprasad, AICAR BUSINESS SCHOOL

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