MACRO ECONOMICS

By

Geeta Ghai
[M.Phil*, M.A Economics, B.Ed, M.Com, B.Com]

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Circular flow of income
It refers to cycle of generation of income and
its distribution among the factors of
production(land, labour, capital and
enterprise) and finally its circulation from
household to firms in the form of
consumption expenditure

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 1 •Production Phase

2 •Income phase

3 •Expenditure Phase

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Production Phase
Production refers to “value addition”

The producing sectors hires/purchases factors of

production from households who are the owner of
these factors(Land, labour, capital and enterprise).
The factor inputs are used along with non factor
inputs(raw material, etc.) for the production of goods
and services.

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Income Phase/Phase of distribution
For rendering their factor services to the producers,
the households get factor payments: rent for land,
interest for capital, wages/ salaries for labour and
profit for entrepreneurship.
Form the viewpoint of the households, these are factor
incomes.

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Phase of Disposition/Expenditure
Income is spent or disposed of on the purchase of final
goods and services.
When households buy the final goods, there is
consumption expenditure.
When producers buy the final goods, there is
investment expenditure.

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Types of circular flow
Real flow(Physical flow)

• Without involvement of money

Money flow(Nominal flow)

• Involvement of money

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Assumptions of the model
There are only two sectors in the economy namely
households and producers
The households spends their entire income, so that
there are no savings.
The domestic economy is a closed economy, so that
there are no exports and imports.
There is no government in the domestic economy.

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Real flow/Physical flow
Firm
Factor services

Goods and services

Househol
d
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Money Flow/ Nominal Flow
Firm
Consumption
Expenditure

Factor payment

Househol
d
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Circular flow of income

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Injections and leakages (Including financial
sector)
All savings by households and firms go to the financial
market.
Financial market invests this money by lending out to
firms and to household sector.
In this case leakages are savings by households and
firms.
These become injections into the circular flow when
borrowed by households and firms for investment.

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Difference between leakages and injections
Leakages
1 These flow variable have a negative
impact on the process of
production.
2 These are withdrawals from
circular flow of income
3 Effect on economy: leakages
Reduce flow of income/production
Reduce demand of goods and
services.
4 Example savings, taxation, imports
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Injections
These cause positive impact on the
process of production or income
generation
These are additions to the circular flow
of income
Effect on economy: add to the
production capacity of the economy.
Generate demand of goods and services
Example investment, exports,
consumption exp.
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Observations
Factor payments by firms = value added by the firm
Total production of goods and services by firm = total
expenditure on goods and services by the household
sector.
Value addition = income generated = expenditure on
goods and services.

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Difference between Real flow and Money
flow
Basis It is flow of goods and It is the flow of money
services between between firms and
firms and households households.
Kind of It involves exchange of It involves exchange of money
exchange goods and services
Difficulty in There may be There is no such difficulty in
exchange difficulties of barter case of money flow.
system in exchange of
goods and factor
services
Alternative It is also known as It is also know as nominal
Name Physical Flow. flow.

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Significance of circular flow of income
Estimation of national income: Circular flow model
facilitates the estimation of national income. National
income in the sum total of factor incomes (rent +
profit + wages + interest) flowing from producers to
households of a country. It may also be defined as the
market value of the goods and services flowing from
producers to other sectors of the economy. Further, it
may be defined as the sum total of expenditure on the
goods and services produced by the producer sector.

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Knowledge of intersectoral
interdependence
A circular flow model helps understand
interdependence among different sectors of the
economy. We learn how consumers are dependent on
producers and vice versa.

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Type of variables
•Measured at a
Stock particular point of time

•Measured over a
Flow period of time

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Difference between Stock and Flow
Basis Stock Flow
Meaning Stock variable refers to Flow variable refers to that
that variable, which is variable, which is measured
measured at a over a period of time.
particular point of
time.
Time It does not have a time It has a time dimension as its
dimension dimension. magnitude can be measured
over a period of time.
Nature of It is static concept. It is a dynamic concept.
concept
Examples National wealth. National income
Quantity of wheat Quantity of wheat produced
stored

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Let’s test ourself
Are the following stocks or flow?
Investment
Flow
Monetary expenditure
Flow
A hundred rupee note
Stock
A family’s consumption of sugar
Flow

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Service of a tutor
Flow
Production of cement
Flow
Machinery of a sugar mill
Stock

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Thank you

Geeta Ghai
M.Phil*, M.A Economics, B.Ed, M.Com, B.Com

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