Module I: Concepts and variables

in Macroeconomics and Circular

flow of Income
By Shikha Singh
 Chapter objectives
 Learning that in a two-sector economy, the sum total of the factor incomes earned by the
households is equal to the total of the expenditures by the households on the goods and
services.
 Understanding that there exist withdrawals and injections which prevent the circular flow
of income and money from remaining constant.
 Learning that the main source of revenue for the government is through taxes.
 Explaining that a government may follow a balanced, deficit or a surplus budget.
 Understanding that there exists a flow of income between the government sector and the
capital market.
 Learning that the import and export of goods and services influences the circular flow of
income.
 Understanding that in general the exports of a country are rarely equal to the imports.
 Introduction

There is flow of the factors of production, goods and

services and money in a two-sector, three-sector and a four-
sector economies.
In any economy, there are two kinds of flows.
Real flows include the flows of the factors of production
and the goods and services between the different sectors.
Money flows includes the monetary flows between the
different sectors.
Circular Flow of Economic Activities and
Income
The simple model of the circular flow assumes two players
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
• Take joint decision about the consumption of goods and services.
• 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
 Circular Flow of Income
(Two Sector Economy)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)
Factor Inputs

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

Goods and
Services (O)

Consumption
expenditure
(C)

In the equilibrium Y=E=O

 Circular flow of income: two sector economy
 In a two-sector economy, there are only two sectors, households and firms.
 By definition, the national income is equal to the national expenditure.
 In a two-sector economy, the total income earned by the households must be equal to the total
expenditure in the economy.
 The firms are engaged in the task of production by combining the different factors of production.
 The owners of these factors are the households.
 The goods produced by the firms are bought by the households.
 The payments made by the households for these goods and services are utilized by the firms to make
the factor payments.
 The analysis is based on certain assumptions.
 There are no savings by the household sector.
 There are no inventories.
 There are no retained earnings by the firm.
 Withdrawals and injections in the economy
 Withdrawal (or leakage) is income which is generated in the production of the national
output and which does not become a part of the circular flow of income.
 There are three types of withdrawals in an economy—saving, taxes and imports.
 Withdrawals lead to a decrease in the circular flow of income.
 Injection is an amount of money which is spent by the different sectors in the economy.
 It is in addition to their incomes generated in the circular flow of income.
 There are three types of injections in an economy—investment, government expenditure
and exports.
 Injections result in an addition to the circular flow of income.
 If injections are greater than the leakages, the circular flow will grow and there is
prosperity in the economy.
 If injections are less than leakages, the circular flow will become smaller in size and there
is a recession in the economy.
 In equilibrium, the leakages are equal to the injections and the size of the circular flow
remains the same.
Withdrawals and injections in
the economy
 The Circular Flow in a Three-Sector Economy
 We now introduce a third sector, the government sector.
 The government is involved in many activities.
 Figure (in the next slide) depicts the circular flow of income in a three-sector economy.
 It shows the economic transactions between the households, firms and the government sector.
 The government raises its revenue from many sources.
 It is assumed that taxes form the only source of revenue for the government.
 Taxes include those levied on the households sector and those levied on the firms.
 We can divide the government expenditures under four heads.
 Payments are made to the household sector.
 Payments are made to the firms for the goods and services bought from them.
 Subsidies are given to the firms.
 Payments are made to social security and welfare.
 The government may follow a balanced, deficit or a surplus budget.
 In today’s world, the government often follows a deficit budget.
 A deficit budget implies net injections and thus an expansion in the circular flow of income.
 It is important to note that a part of the flows between the households and the firms now gets diverted to the government
sector.
 In addition, there may also exist a flow of income between the government sector and the capital market.
 If the government follows a deficit budget, money will flow from the capital market to the government sector.
 If the government follows surplus budget, money will flow to the capital market from the government sector.
The Circular Flow in a Three-Sector Economy
 Circular Flow of Income
(Four Sector Economy)

The third sector is Government (G)

• Government Spending
– On provision of public utility goods and services.
– Provides salaries to the households
– Pays to firms for purchases of goods and services
• Government Revenue
– Households and firms pay various taxes and other payments and
provide factor inputs to the government.
– Government borrows from the financial market to fill revenue gap.
The fourth sector is the external sector
• Imports (M): Outflow of income occurs when the domestic firms buy
goods and services from foreign ones.
• Exports (X): Inflow of income takes place when foreign firms buy
goods and services from domestic ones
 The Circular Flow in a Four-Sector Economy
In a four-sector economy, besides the household, firms and the government, the
fourth sector is the foreign sector.
Figures (in the next slide : both figures in the next two slides can be considered
based on the assumptions: students already made to write in class) depicts the
circular flow of income in a four-sector economy.
It shows the economic transactions between the households, firms, government and
the foreign sector.
The import and export of goods and services influences the circular flow of income.
Imports lead to an outflow of income and thus to a decrease in the circular flow of
income.
Exports lead to an inflow of income and thus to an increase in the circular flow of
income.
In general, the exports of a country are rarely equal to the imports.
When the exports of a country are less than its imports or X < M, there is a foreign
trade deficit equal to
(M – X).
When the exports of a country are greater than its imports or X > M, there is a
foreign trade surplus equal to (X – M)).
The Circular Flow in a Four-Sector Economy
Diagram from :Macroeconomics: Theory and Policy by Vanita Agarwal
 Circular Flow of Income
(Four Sector Economy)
Government
(G)
Remittances
Taxes Factor Taxes for purchases
Salaries Payments
Factor Inputs

Savings (S)

Households Financial Market Investment Firms

(I)

Exports Goods
Exports
Consumption
Expenditure

Imports Foreign Nations Imports

(X-M)
 Macro-economic Variables

• Aggregate Demand and Aggregate Supply

– Aggregate Demand is the sum of demand for all goods and
services by all the consumers for a given period of time.
• aggregate demand (AD) for consumer goods i.e. consumption
demand (C)
• aggregate demand for capital goods i.e. (I).
Thus AD = C+I
• Aggregate supply is the total national output produced and supplied by
all the factors of production in an economy.
• It refers to the supply of all goods and services in the economy for a
given period of time.
• Aggregate supply (AS) consists of
– supply of consumer goods (C) and
– Supply capital goods (where capital comes from savings (S),
Hence AS=C+S
 Macro-economic Variables

• Stock and Flow

– Stock may be defined as any economic variable which has
been accumulated at a specific point of time
• like money, assets and wealth.
– Flow includes the variables which increase (inflows) and
decrease (outflows) the stock, over a period of time.
• like income, consumption, saving and investment
Stock=Inflows-Outflows
• Intermediate and Final Goods
– Intermediate goods (and services) are items purchased by
firms for using them in production of some other good of utility.
– Also known as producer goods because they are used as
inputs in the production of other goods.
 Macro-economic Variables
• Capital formation
– The process of savings being converted into investment is known as
capital formation
– Gross Capital Formation refers to the aggregate of additions to fixed
assets (Fixed Capital Formation) and increase in stocks of inventories
during a period of time.
• Employment
– An employed person is willing and capable to work in a productive activity
and is engaged for certain number of hours per week, whether working for
self or someone else.
– The population of any country is divided into working population (age
group of 16 to 65 ) and dependents.
• Government Expenditure and Revenue
– Government Expenditure is which is made from public exchequer.
– Government Revenue is income received by government in various
forms, e.g. Taxes
Note: Students need to combine the notes
with ppt for further studying of the topic.

Thank you