THE CIRCULAR FLOW OF
INCOME
Lecturer:
Sadia Naseem Naik
MPhil. (Economics)
PhD Scholar
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WHAT IS A CIRCULAR FLOW OF INCOME?
The circular flow of income shows the connection or linkages between different sectors of
the economy.
It can be explained with the help of economic models.
The circular flow model
is a picture of market economy in
action. It tells how the money
flows in the economy.
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TYPES OF CIRCULAR FLOW MODELS
Two sector model
Three sector model
Four sector model
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TWO SECTOR MODEL
It consists of household sector and the industrial
sector.
Household sector demand goods and services and they
provide labour resources to the business sector.
Industrial sector produce and supply goods and
services to the household sector
Businesses demand resources for production: land,
labour, capital, and entrepreneurs.
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Household sector
Spending
Factor Incomes Products Factor Services
Firms/ industrial sector
Factor Incomes Factor Services
Wages/Salaries Labour
Interest Capital
Profit Entrepreneur
Rent Land 5
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Circular Flow of
Income in a Two-
Sector Economy
It is defined as the flow
of payments and
receipts for goods, Total
expenditure
services, and factor (E) = C + I
services between the
households and the firm
Total income
sectors of the economy. (Y) = C + S
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EXPLAINATION : Expenditure made by the households on the
goods and services produced by the firms,
while the flow of goods and services is in opposite direction
from business firms to households. Thus we see that money
flows from business firms to households as factor payments
and then it flows from households to firms. Thus there is, in
fact, a circular flow of money or income. which shows the
households immediately spend all the income they receive to
purchase goods and services from the firms that pay them
their incomes.
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THREE SECTOR MODEL
It is called the closed economy model.
It includes the
household sector
industrial sector
government sector – the
government collects taxes to provide
resources and services to the people.
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goods & services… Product ….goods & services
Markets
….consumption spending….
Government sector industrial sector
Household sector
….salaries, wages, rent, dividends…..
Factor
land, labor, capital…… Markets …entrepreneurial ability
goods & services… Product ….goods & services
Markets
….consumption spending….
Personal Income Taxes
transfer payments Government subsidies
sector industrial sector
Household sector
Corporate Income Taxes
….salaries, wages, rent, dividends…..
Factor
land, labor, capital…… Markets …entrepreneurial ability
Circular Flow of Income in a
Three-Sector Economy
It is defined as the flow of
payments and receipts for goods,
services, and factor services Total expenditure
among the households, the firm (E) = C + I + G
Total income
sectors and the government.
(Y) = C + S + T
Since expenditure
incurred must be
equal to the income
received (Y), we
have C + I = C + S
or, I = S
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It is closed economy because it has no connection with the rest of
the world. Households do not spend all of their income on
consumption. Part of it "leaks out" of the basic circular flow of
income and consumption through payments of taxes and through
saving. (Y) = C + S + T
These two leakages are balanced by "injections" of expenditure
into the basic circular flow in the form of government purchases
and investment. Total leakages (S + T) must equal total injections (I
+ G) for this simple closed economy.
(E) = C + I + G
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The first injection is government purchases of goods and services plus transfer
payments is called government expenditures or, sometimes, government
outlays.
The second injection is investment. Investment, as the term is understood in
macroeconomics, is made up of two components. The first, fixed investment,
means purchases of newly produced capital goods—machinery, office equipment,
software, farm equipment, construction of buildings used for business purposes,
including construction of rental housing, and so on.
The second component, inventory investment, means changes in stocks of
finished goods ready for sale, stocks of raw materials, and stocks of partially
completed goods in process of production. Inventory investment has a negative
value if stocks of goods decrease in a given period.
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Second, the financial sector plays a key role in redirecting flows of funds
between the private and government sectors of the economy. If government
purchases exceed net taxes, the government has a budget deficit. G˃T,
To cover the deficit, the government must then borrow from the private
financial sector. If the government runs too large a deficit, borrowing too much
from financial markets, not enough saving may be left over to meet the
country’s investment needs. That can result in a condition of high interest rates
and slow growth for the economy as a whole.
On the other hand, the government sometimes collects more in net taxes than
it spends on purchases of goods and services. In that case, the budget is in
surplus. G˂T. The surplus funds are used to repay past debt.
On the other hand, if the government has a budget surplus, additional funds
flow into financial markets that can help keep interest rates low and stimulate
private investment.
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FOUR SECTOR MODEL An Open Economy
• Trade and Commerce is necessary
The is called the open economy model. condition
It consists household sector • But inflow and outflow of capital is
industrial sector sufficient condition
government sector • Households provide Labour services to
foreign sector and receive remittances
financial sector and the
foreign sector. • Firms import and export goods and
services to foreign sector.
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Circular Flow of Income in a Four-Sector Economy
It is defined as the flow of payments and receipts for goods,
services, and factor services among the households, the firm
sectors ,the government and the foreign sector.
National Income = C + I + G + NX where NX represents net exports, X-M.
Since national income can be either consumed, saved or paid as taxes to the
Government we have
C + I + G + NX = C + S + T
MONEY FLOWS WITH FOREIGN SECTOR
• Exports of goods and services + Borrowing foreign funds + non-
debt investments coming from foreign countries leads to INFLOW
OF MONEY to domestic economy from foreign countries.
• Imports of goods and services + Lending to foreign countries + non-
debt investments in foreign assets leads to OUTFLOW OF MONEY
from domestic economy to foreign countries.
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• Exports = Imports , then Net exports = zero
• Net exports = X – M
• Shows balance between reciepts and payments
• But X – M can be positive or negative
• The magnitude of circular flow will be more if X > M
• The magnitude of circular flow will be less if X < M
• The magnitude of circular flow will be same if X= M
• Thus, Y = C + S + T + X is income
• E = C + I + G + M is expenditure
• For all 4 sectors of the economy to be in equilibrium we must
have
S=I , T=G, X=M
The open economy is another leakage, imports and imports represented as a
leakage, not an injection. The part of household income that is devoted to
purchase of goods and services produced in the rest of the world, rather than in
the domestic economy.
A new injection, exports, to match the import leakage.
As government purchases do not always exactly equal net taxes, resulting in a
government surplus or deficit, imports do not always exactly equal imports,
resulting in a surplus or deficit of payments with the rest of the world. In the
context of the circular flow, we call this external surplus or deficit net exports,
which means exports of goods and services minus imports.
Leakages, Money exits the circular flow model
Injections, Money enters the circular flow model
Sectors Leakages Injections
Government Tax Transfer
payments,
subsidy
Foreign Imports Exports
Financial Savings Investment
USES OF CIRCULAR FLOW MODELS
It gives the clear picture of the market economy.
It helps in the calculation of national income.
Formulation of trade policies which promotes the exports and reduces the imports.
It explains the importance of monetary policy by establishing equilibrium between
savings and investment.
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