CIRCULAR

FLOW OF
INCOME
 INTRODUCTION
Price is the basic parameter of Microeconomics. However, the basic parameter of Macroeconomics is the
"Circular Flow of Income". As we know, national income is a flow concept. A large number of goods and
services are produced in an economy every year, which gives rise to national income. These goods and services
are produced in the production units by combining different factors of production. Producers purchase the
factor services to produce goods and services. The national income or output generated is distributed as factor
income to the owners of factors of production in the form of various factors that come as wages, rent, interest
and profits.

The factor incomes earned or generated are spent on the purchase of goods from the production units. These
expenditures generate income for the producers. As such, production gives rise to income, income gives rise to
expenditure and expenditure gives rise to income again, and this process continues. Thus, in an economy goods
services and factor services are constantly exchanged between different individuals like producers and
households. This flow of goods and services and factor services among producers, households and other
individuals in an economy.
● Circular Flow of Income is defined as the flow of payments and receipts for goods and services and
factor services between different sectors of the economy. Circular Flow can be viewed from two angles:
real and money flow.
● Real Flows: Real flows consist of the flow of factor services and goods and services among different
sectors of an economy.
● Money Flows: Money flows consist of the flow of money incomes for factor services such as money
wages, rent, interest, etc. and money expenditure incurred on the purchase of goods and services.
● Note: Real flow determines the magnitude of economic growth, the more the factor services offered to the
firms, the more is the volume of production and it, therefore, speeds up the process of economic growth.

● The economy is divided into four sectors:

● i) Household Sector
● ii) Business Sector or Firms
● iii) Government Sector
● iv) Rest of the world
TWO- SECTOR ●In the two-sector model of national income

MODEL accounting there exists only households and

firms.
●The assumptions of this model are as follows;
 Only two sectors – Households and firms.
 There exists no government intervention
over economic activities.
 The business sector does not carry out
economic activities, thus creating a closed
economy.
●We can represent the two-sector model as
follows beside;
 REAL FLOW AND MONETARY
FLOW
●Real flow indicates the flow of factor services from households to businesses and the flow of
goods and services from the business sector to the households.
●Monetary flow, on the other hand, indicates the flow in terms of money, factor rent, wage,
interest, and profit from the business to the household sector, and the consumption expenditure
made by household flow to the business sector as revenue for the firms. Thus, in our two-sector
simple economy with neither government nor foreign trade, investment is identically equal to
saving.
●Therefore, in this model we can reach the following equation,
●Monetary receipts of producers = Income of households = Consumption expenditure by the
households.
 WITH SAVING AND
INVESTMENT
• Households do not spend their entire income on
consumption. A part of the income which is not
spent by the households on consumer goods is
called savings.
• Savings by the households reduces the
consumption expenditure and the level of circular
flow of income. Thus, savings represents a type of
leakage.
• Investment expenditure on the other hand,
creates income for the firms that produce capital
goods and for the factors used in the production
process. Investment increases the level of income
so it’s an injection.
In this model, a new sector referred to as the capital market is introduced. A part of the income of
households flows to the firms in the form of consumption expenditure and a part of the income
flows to the capital market in the form of savings.
In this model of circular flow, if the investment expenditure by the firms is equal to the savings of
the household sector, then there will be equilibrium.
Therefore, the equilibrium condition;
Savings = investment
• If S>I – The flow of income declines this is because the leakages are more than the injections.
• If I>S – The flow of income increases this is because injections are more than leakages.
 THREE – SECTOR MODEL
● In this model, there exist the government sector, the
household and the firm.
● The three major activities of the government in this sector
include:
i) Taxation
ii) Government spending on commodities and factor services
iii) Transfer Payments

● The expenditures which are incurred by the government on

various social security and welfare schemes are known as
transfer payments. Example: Pensions and scholarships.
● Taxes constitute the leakages from the flow of income, as
they reduce the income of the individual.
●Government expenditure (G), on the other hand, is injection into the flow of income as it adds to
aggregate demand in the form of government purchases of factor services.
●If the government somehow manages to spend all its leakages from the circular flow or the income
received in the form of taxes, it flows back to the households and business sector in the form of
subsidies and other government expenditures. This leads to continuous circular flow of national
income within the economy of the any country.
●In this model, the equilibrium condition is as follows;
●Savings + Taxes = Investment + Government Expenditure
 When ( S + T ) > ( I + G ) – This means that the leakage of income from the circular flow is greater
than the injection into the circular flow.
 When ( I + G ) > ( S + T ) – This means that the injection into the circular flow is greater than the
leakage from it.
FOUR-SECTOR MODEL
• The four sector model analyses the circular flow in an open
economy comprising the household sector, business sector,
government sector and the foreign sector.
• The happenings in each of the four sectors can be considered
as follows;
• Household sector;
• Receipts – Factor income is received in the form of rent,
wages, interest, and profit from the business sector. It also
receives transfer payments from the government sector in the
form of age-old pensions and various welfare schemes.
• Payments – Income flows into the government sector,
business sector and the capital markets in the form of
consumption expenditure, taxes, and savings.
 Business sector;
Receipts – Income from the sale of goods and services, income from exports, subsidies from the government
sector and borrowings from the capital markets.
Payments – Principle payments are factor payments, import payments and savings from the business to the
household sector, government sector, foreign sector, and the capital markets.

Government Sector;
Receipts – Major sources of income include taxes paid by the household and the business sector. It also receives
interest and dividends for the investment made.
Payments – Makes payments in the form of transfer payments, subsidies, grants, etc. In the case of a cash
deficit, the government borrows from the capital market to maintain a balance in the economy.

Foreign Sector;
Receipts – Receives income from the business sector in the form of goods and services imported by the business
sector.
Payments – Payments to the business sector from where the imports have been made.
The imports ( M ) constitute the leakages from the circular flow.
The exports ( X ) constitute the injections into the
circular flow.
The equilibrium condition in the four-sector model
is as follows;
S+T+M=I+G+X
Where,
S = Savings
T = Taxes
M = Imports
I = Investment
G = Government expenditure
X = Exports
 CONCLUSION
The circular flow of income as established is the basic parameter in macroeconomics. The importance of the circular
flow concept is evident from the following:

1. The entire economic system can be viewed as a circular flow of income and expenditure. The circular flow of income
shows how different sectors of the economy, namely the household sector, the business sector, the government sector
and the rest of the global economy are interrelated and interdependent. The circular flow of income gives an
overview of the interaction between the different sectors of an economy.

2. The magnitude of these flows determines the size of income. We can, therefore, measure the national income from
the money flows. The national income can be estimated with the help of output, income and expenditure phases of
the circular flow of income.

3. The study of the circular flow of income pinpoints the conditions of macroeconomic equilibrium. It spells out the
conditions for the equilibrium level of income in an economy. For instance, equality between saving and investment
is the equilibrium condition in a two-sector model.
Thank You!