UNIT-IV

CIRCULAR FLOW OF INCOME

 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 Firms

Financial Foreign Sector

Institutions Government
 Households
• 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, defence 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.
 MODELS
Three
Two
Secto
secto
r
r
Four Five
Secto Secto
r r
 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.
 Leakages and Injections
LEAKAGES INJECTIONS

SAVINGS( S) INVESTMENTS (I)

TAXES ( T) GOVERNMENT SPENDINGS ( G)

IMPORTS (I) EXPORTS (E)

• 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+M=I+G+X
 Dis- equilibrim
• 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+M≠I+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.