Circular Flow of Income

Dr. Akshay Dhume

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Reading Material
 01B. Ahuja Chapter 2
 01B. Dwivedi Chapter 3

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Circular Flow of Income
 Economy can be defined as an integrated system of production, exchange and
consumption

 People are involved in making transactions – buying and selling goods and services

 Economic transactions generate 2 types of flows

◦ Product Flow: flow of goods and services
◦ Money Flow

 Flow begins with flow of factors of production

◦ Generates money flow in form of factor payments or income flows
◦ Factor incomes are spent on consumer and capital goods generating expenditure flows (money
flow)

 Magnitude of the flows determine the size of national income

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Circular Flow of Income
 Economy is divided into 4 sectors:
◦ Household Sector
◦ Business Sector/Firms
◦ Government Sector
◦ Foreign Sector

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Circular Flow of Income: 2-Sector Model
 Assumptions for Simple Model
◦ Households spend their entire income – no saving
◦ Firms produce goods and services only as much as demanded
by households – no inventory
◦ Factor payments are made to households – include rent, wage,
interest and profits
◦ No inflow and outflow of income or of goods and services
from external sources

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Circular Flow of Income: 2-Sector Model

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Leakages and Injections

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Circular Flow of Income: 2-Sector Model
(with Financial/Capital Markets)

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Circular Flow of Income: 3-Sector Model

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Circular Flow of Income: 4-Sector Model
 Foreign sector consists of 2 types of transactions
◦ Foreign trade: export and import of goods and services
◦ Inflow and outflow of capital

 Assumptions
◦ External sector consists of only exports and imports
◦ Export and import of goods and non-labor services are made
only by firms
◦ Households exports only labor

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Circular Flow of Income: 4-Sector Model

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