CIRCULAR FLOW OF INCOME

The moderm economy is a monetary economy. In the modern economy, money is used in the
process of exchange. Money has facilitated the process of exchange and has removed the difficulties
of the barter system. Thus money acts as a medium of exchange. The households supply the
economic resources or factors to the productive firms and receive in return the payments in terms
of money. In is thus clear that, in the monetary economy, there will be flows of money
corresponding to the flows of economic resources and the flows of goods and services. But each
money flow is in opposite direction. to the real flow.

Aggregation: The main principle of macroeconomic analysis is aggregation. Aggregation means

putting all the units together. The subject matter of macroeconomics is to study aggregate economic
behavior, i.e. behavior of aggregate (macroeconomic) agents on aggregate (macroeconomic)
markets. There are four macroeconomic agents and four macroeconomic markets.

Macroeconomic Agents
A. Households
 the owners of economic resources (suppliers of factors of production);
 the earners of national income;
 the main consumers of goods and services (demanders for aggregate output);
 the main savers (lenders)

B. Firms
 the main producers of goods and services (suppliers of aggregate output);
 the main demanders for economic resources;
 the consumers of the part of aggregate output (demanders for investment goods);
 the main borrowers

Households and firms form the private sector of the economy.

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 the producer of public goods;
 the consumer of the part of aggregate output (purchaser of goods and services);
 the redistributors of national income (through collecting taxes and making transfer
payments);
 lender or borrower in the financial markets (depending on the state of government budget);
 the regulator of economic activity:
 establishes and supports institutional basis for the economic performance (“rules of the
game”)
 Conducts macroeconomic policy

Private and government sectors form the closed economy (or the mixed closed economy), that is
the economy not interacting with other economies.

D. Foreign sector: Interacts with the national economy through two channels:
 international trade: exchange of goods and services
 capital flows: exchange of assets, primarily financial (bonds and shares)

Economy that interacts with other economies (with the rest of the world) is called the open
economy
Macroeconomic Markets
 Goods (or product) market
 Resource (or factor) market
 Financial market: which consists of two segments: money market bonds market
 Foreign Exchange Market

Model of Circular Flows

In order to understand how the aggregate economy works and to analyze the aggregate economic
behavior economists use the model of circular flows that represents the interaction between
macroeconomic agents through macroeconomic markets.

Circular Income Flow in a Two-Sector Economy

We begin with the simple or private or two-sector model, consisting of two macroeconomic agents
(households and firms) and two macroeconomic markets (goods market and resource market).

Simple (Private Sector) Diagram of Circular Flows

 Goods flow from firms to households through the goods (product) market and economic
resources flow from households to firms through the resource (factor) market.
  Firms pay factor incomes (wages, rent, interest and profits) to households - the owners of
economic resources and households spend their incomes buying goods and services. Hence,
 Aggregate income is equal to aggregate expenditures: (all income is spent, all expenditures
translate in somebody’s income); aggregate expenditures are equal to aggregate product
Therefore aggregate product is equal to aggregate income.

 Movement of income, expenditures and product form a circle. Thus, we have circular flows .
Private Sector Diagram of Circular Flows with Financial Market

The Role of Financial Markets

Being rational, households spend only part of their income, the rest they save, because saving can
bring extra income, if money is used in the financial markets in the form of:
 a deposit in a bank, or
 a purchase of a security (an equity or a bond), issued by firms
Saving of households are used by firms to buy investment (or capital) goods (equipment and
structures), necessary to maintain and to expand the level of output.

Spending, made by firms for the purchase of investment goods, are called investment spending. To
obtain funds, firms take loans from the banks or issue and sell securities to households. Financial
markets connect saving and investment.

Expenditures and Income in the Private Sector Model

Expenditures are now divided into two parts:
 consumption spending of households (C)
 investment spending of firms (I)
AE = C + I
Income is also divided into two parts:
 consumption spending (C)
 saving (S)
Y=C+S
The equalities between aggregate expenditures (AE) and aggregate income (Y), and between
aggregate income and aggregate product are still held:
AE ≡Y

In a simple economy which has neither government, nor foreign trade, the value of output produced
which we denote by Y is equal to the value of output sold. Since the value of output sold in a Simple
two-sector economy is equal to the sum of consumption expenditure and investment expenditure,
we have,
Y≡C+I……………………….. (1)
Where Y = = Value of aggregate output, C = Consumption expenditure and I = Investment
expenditure.
A pertinent question which arises here is what happens to the unsold output. The unsold output
leads to the increase in the inventories of goods and in national income accounting increase in
inventories of goods is treated as a part of actual investment. This may be considered as the firms
selling the goods to themselves to add to their inventories. Thus, gross national product (GNP)
produced is used either for consumption or for investment.

Now, look at the gross national product or income in the simple economy from the viewpoint of its
allocation between consumption and saving. Since national income (which is equal to GNP) can be
either consumed or saved, we have
Y≡C+S…………………………. (2)
From the identities (1) and (2) we get,

C + I ≡ Y ≡ C + S…………….. (3)

The left-hand side of the identity (iii), namely C+I≡ Y shows the components of aggregate demand
(that is aggregate expenditure on goods and services produced) and the right-hand side of the
identity (iii) namely Y≡C+S shows the allocation of national income to either consumption or
saving. Thus, the identity (iii) shows that the value of output produced or sold is equal to the total
income received. It is income received that is spent on goods and services produced. Now
subtracting the consumption (C) from both sides of the identity (ii) we have
I≡S
Thus, in our two-sector simple economy with neither government, nor foreign trade, investment is
identically equal to saving.

It means that injections are equal to leakages.

Injection is something that increases the flow of spending and leads to the increase in output and
income.

Leakage is something that withdraws from the flow of spending and can cause the decrease in
output and income.

Investment is an injection, saving is a leakage.

Circular Income Flow in a Three-Sector Economy with Government Sector

In our above analysis of money flow, we have ignored the existence of government for the sake of
making our circular flow model simple. This is quite unrealistic because part of the incomes earned
government absorbs a good by households. Government affects the economy in a number of ways.
Here we will concentrate on its taxing, spending and borrowing roles.

Government purchases goods and services just as households and firms do. Government
expenditure takes many forms including spending on capital goods and infrastructure (highways,
power, communication), on defence goods, and on education and public health and so on.

Government expenditure may be financed through taxes, out of assets or by borrowing. The money
flow from households and business firms to the government is labelled as tax payments. This
money flow includes all the tax payments made by households less transfer payments received
from the Government.
Transfer payments are treated as negative tax payments. Transfers to households (Tr) & subsidies
to firms (Sb) which are government payments that involve no direct service by the recipient.
Transfers include:
 unemployment insurance payments;
 welfare payments to households.
 In addition to transfers persons receive interest on public debt (i× BGov)

Another method of financing Government expenditure is borrowing from the financial market. This
can be represented by the money flow from the financial market to the Government and is labelled
as Government borrowing. Government borrowing increases the demand for credit which causes
rate of interest to rise. The government borrowing through its effect on the rate of interest affects
the behavior of firms and households. Business firms consider the interest rate as cost of borrowing
and the rise in the interest rate as a result of borrowing by the Government lowers private
investment. However, households who view the rate of interest as return on savings feel
encouraged to save more. It follows from above that the inclusion of the Government sector
significantly affects the overall economic situation.

Diagram of Circular Flows with Government

(Mixed Closed Economy)
Total expenditure flow in the economy is now the sum of consumption expenditure (denoted by C),
investment expenditure (I) and Government expenditure (denoted by G). Thus
Total expenditure (E) = C+I+ G……………………..1
Total income (Y) received is allocated to consumption (C), savings (S) and taxes (T). Thus
Y = C + S + Tx – Tr………………2
Since expenditure (E) made must be equal to the income received (Y), from equations (1) and
(2) Above we have,
C+I+ G ≡ C + S + Tx – Tr………….3
I + G + Tr ≡ S + Tx………………….4
We get two injections: G and Tr and a leakage: Tx.

By rearranging we obtain,
G + Tr – Tx = S –I……………………...5

Equation (5) is very significant as it depicts what would be the consequences if government budget
is not balanced.

Taxes represent the revenues of the government. Government purchases of goods and services and
transfers are its expenditures. The balance between the government revenues and expenditures is
called government (or public) budget.
 If revenues exceed expenditures (Tx > G + Tr), there is budget surplus.
 If they are equal (Tx = G + Tr), the budget is balanced.
 If expenditures exceed revenues (Tx < G + Tr), government runs budget deficit

To finance budget deficit government either takes a loan (borrows funds) from financial market,
issuing and selling government bonds to the public or prints money. For this purpose, the private
investment (I) by business firms must be less than the savings (S) of the households. Thus
Government borrowing reduces private investment in the economy. In other words, Government
borrowing crowds out private investment.

Another important conclusion that can be drawn from national income account identity
incorporating Government expenditure relates to the condition for equilibrium in the financial
market. National income identity with government expenditure is
Y=C+I+G
Or Y – C – G = I………………………6

In the expression (6), the left hand side (Y-C- G) represents national saving or simply saving (S).
Note that in this National Income Identity all government expenditure is treated as consumption
expenditure. To understand the identity (6), we break up its left-hand side representing national
saving into two parts, namely. (1) Private saving (Y + Tr - Tx - C) and (2) public saving (i.e. saving of
the government (Tx - Tr - G). Thus,
S = (Y + Tr - Tx - C) + (Tx - Tr - G) = Y –C - G

If there is budget surplus, government is a saver. The excess of government revenues over
government expenditures is called public (or government) saving (SG):
SG = Tx – (G + Tr)
With the appearance of the government sector aggregate income, earned by households, (national
income Y) differs from the income that they can use for consumption and saving (disposable
income YD):
YD = Y – Tx + Tr
YD = C + S
If the economy is to remain in a steady state, the flows into the financial market (i.e., private saving
and public saving) must balance the flows out of the financial market. Thus, for the economy to
remain in a steady state
(Y + Tr - Tx - C) + (Tx - Tr - G) = I

That is, for the economy to remain in a steady state, the sum of private saving and public saving
must equal investment.
Money Flows in the Four-Sector Open Economy: Adding Foreign Sector
Diagram of Circular Flows with Government and with Foreign Sector (open economy)

We now turn to explain the money flows that are generated in an open economy, that is, economy
which have trade relations with foreign countries. Thus, the inclusion of the foreign sector will
reveal to us the interaction of the domestic economy with foreign countries. Foreigners interact
with the domestic firms and households through exports and imports of goods and services as well
as through borrowing and lending operations through financial market. Goods and services
produced within the domestic territory which are sold to the foreigners are called exports. On the
other hand, purchases of foreign-made goods and services by domestic households are called
imports.

Adding foreign sector, we get new flows.

A country exports domestic goods and services (Ex) and imports foreign-made goods and services
(Im).
Now, aggregate product Y ≡ C + I + G + (Ex – Im). This equation is known as the national accounts
identity.
Difference between exports and imports is called net exports (NX). NX = Ex – Im and represents
country’s trade balance. The country can have trade surplus (Ex > Im) or trade deficit (Im > Ex).

In the open economy there is interaction between countries not only through exports and imports
of goods and services but also through borrowing and lending funds or what is also called financial
market. These days, financial markets around the world have become well integrated. When there
is a trade surplus in the economy, that is, when exports (X) Exceed imports (M), net capital outflow
will take place. By net capital outflow we mean foreigners will borrow from domestic savers to
finance their purchases of our exports. In this way as a result of net capital outflow domestic savers
will lend to foreigners, that is, acquire foreign financial assets.

On the contrary, in case of import surplus, that is, when imports are greater than exports, trade
deficit will occur. Therefore, in case of trade deficit, domestic consumer households and business
firms will borrow from abroad to finance their excess of imports over exports. This means there
will be capital inflow in our economy. As a result, foreigners will acquire domestic financial assets.
In the case of trade deficit the country is a borrower and there is capital inflow: foreign sector
saving (SF) move to the country’s Economy, SF = Im – Ex

Net foreign investment = the purchase of foreign assets by domestic residents – the purchase of
domestic assets by foreigners = capital outflow – capital inflow.
When a domestic resident
 buys and controls capital in a foreign country, it is known as foreign direct investment;
 buys stock in a foreign corporation, but has no direct control of the company, it is known as
foreign portfolio investment

Net foreign investment (NFI) always equals net exports (NX):

NFI = NX or –NFI = –NX
When net exports is positive (Ex – Im > 0), net foreign investment is positive (= net capital outflow).
When net exports is negative (Ex – Im < 0), net foreign investment is negative as well (= net capital
inflow).

The Four-Sector Model: Important Identities

In the open economy the expenditure-income identity is
C + I + G + (Ex – Im) ≡ C + S + (Tх – Tr)
As now we get an extra injection (Ex) and an extra leakage (Im), then the injections-leakages
identity will be
I + G + Tr + Ex ≡ S + Tх + Im
Total investment are identically equal to the sum of total saving:
I ≡ S + (Tx – G – Tr) + (Im – Ex)
This last equation is called the capital formation equation.
Where,
S = Private Saving
Tx – G – Tr = Government (Public Saving)
Im – Ex = Foreign Sector Saving
S + (Tx – G – Tr) = National Saving

From the injections-leakages identity we can also get

 uses-of-private-saving identity:
 S ≡ I + (G + Tr – Tx) + (Ex – Im)
 budget deficit financing identity:
(G + Tr – Tx) ≡ S – (I + NX)

Stock and Flow Variables

Macroeconomic variables can be divided into stocks and flows.
 A flow is an economic magnitude measured per a given period of time (a year, a week, an
hour). All the variables in the model of circular flows (output, income, consumption, saving,
investment, taxes, budget deficit, trade surplus and others) are flows.
 A stock is an economic magnitude measured at a particular point of time (on November 1st ,
2015). Examples: wealth, savings, government debt, capital stock, money supply, number of
unemployed, etc.

Flows add to or diminish stocks. For example, the flow of investment changes the stock of capital;
the flow of budget deficit increases the stock of government debt; the flow of saving affects the
stock of wealth.

The Macroeconomic System:

 It is a market economy which is influenced by external (exogenous) factors:
 natural (weather, earthquakes, spots on the sun, tsunami, eruptions, etc);
 social (revolutions, wars, overturns, etc)

 It has objectives (induced variables):

 economic growth;
 high employment;
 stable prices;
 balance of payments equilibrium

 It uses instruments (policy variables):

 fiscal policy;
 monetary policy;
 income policy;
 foreign trade and exchange rate policy. (Macroeconomic Policy)

Macroeconomic Policy
 Economic Growth Policy: It is aimed to stimulate economic growth in the long run and to
affect productive possibilities of the economy; suggests changes primarily in aggregate
supply.
 Stabilization Policy: is aimed to smooth out business cycle in the short run and to diminish
the depth of recessions and the height of booms; suggests changes primarily in aggregate
demand.