CIRCULAR FLOW OF INCOME

Abhinav Singh Aman Singh

Ishu Mor Gautam Sharma
 Introduction
The term circular flow of income or circular flow
of economic activity refers to a simple economic
model which describes the circulation/flow of
income between producers and consumers.
In the circular flow model, producer is referred to
as firms and consumer are referred to as
households.
The major exchanges are represented as flows
of money, goods and services, etc.
 Determinants

Household Firm

Financial Foreign sector

Government
institutions
 Household
It is a person or group of people that share their
income.
Require goods and services to satisfy their
personal wants.
Owns all resources ( i.e. labor, capital, land
enterprise)
The members of households have two functions.
1. They supply different factors of production.
2. Members of household also work as consumers.
 Firms
An organization that produces goods and services for
sale.
Main objective is to maximize profit in the production
process
Uses resources provided by households to products
goods and services
Sells those good and services for income
The two main functions are as follows:
1. Produce goods and series and supply them in the market
2. Firms purchase inputs or raw materials from households
to use them in the production process.
 Government

Just like households and firms the government

also earns incomes and makes expenses.
Two major functions are:
1. Government earns revenue from either tax or
non tax sources both from households and
firms.
2. Government provides essential public services
such as maintenance of law and order, defense
services, judiciary etc.
 Financial institutions
Consists of banks and non-bank
intermediaries who engage in the borrowing
(savings from households) and lending of
money
The leakage that financial institutions provide
in the economy is the option for households
to save their money.
 Foreign sector
It consists of two kinds of international
economic transactions i.e.
1. Export and import of goods and services
2. Inflow and outflow of capital.
 Two Three
sector sector

Four Five
sector sector
 Two sector model
In the basic circular flow of income, or two sector circular
flow of income model, the state of equilibrium is defined as
a situation in which there is no tendency for the levels of
income (Y), expenditure (E) and output (O) to change, that
is:
Y=E=O
This means that the expenditure of buyers (households)
becomes income for sellers (firms). The firms then spend
this income on factors of production such as labour, capital
and raw materials, "transferring" their income to the factor
owners. The factor owners spend this income on goods
which leads to a circular flow of income.
 Three sector model
It includes household sector, producing sector
and government sector.
Here flows from household sector and producing
sector to government sector are in the form of
taxes.
The income received from the government
sector flows to producing and household sector
in the form of payments for government
purchases of goods and services as well as
payment of subsidies and transfer payments.
 Four sector model
A modern monetary economy comprises a network of four
sector economy these are:
1. Household sector
2. Firms or Producing sector
3. Government sector
4. Financial sector.
Each of the above sectors receives some payments from
the other in lieu of goods and services which makes a
regular flow of goods and physical services. Money
facilitates such an exchange smoothly.
Financial institutions role it is to accept and protect the
savings of consumers and to make investment funds
available to producers.
 Five sector model
In the five sector model the economy is
divided into five sectors:
1. Household sector
2. Firms or Producing sector
3. Financial sector :
4. Government sector
5. Rest of the world sector: transforms the model
from a closed economy to an open economy.
LEAKAGE AND INJECTION
 LEAKAGE INJECTION

SAVINGS (S) INVESTMENTS (I)

TAXES (T) GOVERNMENT

SPENDING (G)

IMPORTS (M) EXPORTS (E)

Injection
Leakage
 Leakage means withdrawal from the flow. When
households and firms save part of their incomes
it constitutes leakage. They may be in form of
savings, tax payments, and imports. Leakages
reduce the flow of income.
Injection means introduction of income into the
flow. When households and firms borrow the
savings, they constitute injections. Injections
increase the flow of income. Injections can take
the forms of investment, government spending
and exports.
 The state of equilibrium
In terms of the five sector circular flow of
income model the state of equilibrium occurs
when the total leakages are equal to the total
injections that occur in the economy. This can
be shown as:
Savings + Taxes + Imports = Investment +
Government Spending + Exports
S+T+MI+G+X
 If the state of the sum of total leakages does
not equal the sum of total injections it will
result in disequilibrium. Disequilibrium can be
shown as:
Savings + Taxes + Imports Investment +
Government Spending + Exports
S+T+MI+G+X
 Significance
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.
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.
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.
Injections and Leakages