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LESSON-2

ASTUDY OF MACRO MODELS- CIRCULAR FLOW MODEL hA

2.1. Introduction dcenss
This chapter is concerned with the study of macro models-circular flow of te
income model. Circular Income Flow in a Two Sectors Economy, Circular Money
Flow With Saving and Investment. The Circular income Flow in a Three-Sector
Closed Economy. The Circular flow in a Four-Sector Open Economy (Adding Foreign
Sector ) and finally, importance of the circular flow in detail. clod
2.2. Objectives

To study Macro models Circular flow mode

Toexamine Circular Income Flow in a Two Sectors Economy

To analyses the Circular income Flow in a Three-Sector Closed Economy

Toexamine The Circular flow in aFour-Sector Open Econony

2.3. Content

2.3.1 A study of Macro models Circular flow model

The moderneconomy is a monetary economy. In the modern economy, money
is used in the process of exchange. Money has facilitated 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 corresponding to the flows of economic resources and the
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flows of goods and services. But each money flow is in opposite direction to the real
flow.

2.3.2Circular Income Flow in a Two Sectors Economy

Real flows of resources, goods and services have been shown in Fig 2.1. In the
upper loop of this figure, the resources such as land, capital and entrepreneurial ability
flow from households to business firms as indicated by the arrow mark. In opposite
direction to this money flows from business firms to the households as factor payments
such as wages rent interest and profits. In the lower part of the figure money flows
Haw4 faw at taetoy seicds. fmhelok to Bhea.
Real
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from households to fims as consumption 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 firns 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. This
circular flowof money will continue indefinitely week by week and year by year

Factor Payments

Land, Labour, Capital, Organisation

Family (House
Company Hold)
(Firms)

Flow of finished goods and services

Consumption Expenditurg

Fig.2.1
The flow of money income will not always continue at a constant level. In year
of depression, the circular flow of money income will contract, i.e., will become lesser
involume, and in years of prosperity it will expand, i.e., will become greater in volume.
This is so because the flow of money is a measure of national income and will,
therefore, change with changes in the national income. In year of depression, when
national income is low, the volume of the flow of money will be small and in years of

weme clong
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 prosperity when the level of national income is quite high, the
large. flow of money will be

2.3.3Circular Money Flow with Saving and

Investment

Land, Labour, Capital, Organisation

Family
Company (House
(Firms) Hold)

Flow of finished goods and services

Fig.2.2

We willnow explain if households save apart of their income, how their savings
will affect money flows in the economy. When households save, their expenditure on
goods and services willdecline to that extent and as aresult money flow to the business
firms willcontract. With reduced money receipts, firms will hire fewer workers (or lay
off come workers) or reduce the factor payments they make to the suppliers of factors
such as workers. This will lead to the fall in total incomes of the households. Thus,
savings reduce the flowof money expenditure to the business firms and will cause a
fall in economy's total income. Economists therefore call savings a leakage fromthe
money expenditure flow.

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 Serkices
Faqtor Supply
Vactor

Family
Demard
Goods Money
Money

Factor
Market
Product
Market

Services
Fastor
Money
Money
Goods
Factor

Demand
Firms Supply

Factor Income

Business
Savings Family
Capital Family (House
Company Savings Hold)
Market
(Fims)
Capital
Debit

Consumer Expenses

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2.3.4 TheCircular income Flow in a Three-Sector Closed Economny

Government Government
Purchases Sector Taxes

Capital Saving Transfer

Investment
Market Payments
Taxes Social Services

Consumption
Expenditure

Product
Market

Business Sector Household Sector

Factor
Market

Income
Payments
Fig,2.3
So far we have been working on the circular flow of a two-sector model of an
economy. To this we add the government sector so as to make it a three-sector closed
model of circular flow of income and expenditure. For this, we add taxation and
government purchases (or expenditure) in our presentation. Taxation is a leakage from
the circular flow.
First, take the circular flow between the household sector and the government
[Link] in the form of personal income tax and commodity taxes paid by the
household sector are outflows or leakages from the circular flow. But the government
purchases the services of the households, makes transfer payments in the form of old
age pensions, employment relief, sickness benefit, etc., and also spends on them to

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 provide certain social services like education, health. housing. water. parks and other
facilities. All such expenditures by the government are injections into the circular flow.
Next the circular flow between the business sector and the government sector.
All types of taxes paid by the business sector to the government are leakages from the
circular flow. On the other hand, the government purchases all its requirements of
transfer
goods of all types from the business sector. gives subsidies and makes
These government
payments to fims in order to encourage their production.
expenditures are injections into the circular flow.
together to show
Now we take the household. business and government sectors
taxation is a leakage
their inflows and outflows in the circular flow. As already noted.
of the household
from the circular flow. It tends to reduce consumption and saving
and incomes of the fims. On
sector. Reduced consumption, in turn, reduces the sales
investment and production.
the other hand, taxes on business firms tend to reduce their
purchases from the business sector
The government offsets these leakages by making
amount of taxes. Thus total
and buying senses of the household sector equal to the
circular flow of income and
sales again equal production of firms. In this way. the
taxes are leakages.
sectors and
Figure 2.3 shows that taxes flow out of the household and business
investment and for this purchases
goto the government. Now, the government makes
govemment
goods from firms and also factors of production from households. Thus
income. and
purchases of goods and services are an injection in the circular flow of
taxes are leakages.
will incur a deficit
If government purchases exceed net taxes the government
taxes. The
equal to the differences between the two, i.e.. government expenditure and
receives
government finances its deficit by borrowing from the capital market which
exceed
funds from households in the form of saving. On the other hand, if net taxes
this case the
government purchases the government will have a budget surplus. In
which are
government reduces the public debt and supplies funds to the capital market
received by firms.

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2.3.5 The Circular flow in a Four-Sector Open Economy (Adding Foreign Sector: )
So far the circular flow of income and expenditure has been shown in the case
of aclosed economy. But the actual economy is an open one where foreign trade plays
an important role. Exports are an injection or inflows into the economy. They create
incomes fro the domestic firms. When foreigners buy goods and services produced by
other hand,
domestic firms, they are exports in the circular flow of income. On the
incurred by the
imports are leakages from the circular flow. They are expenditures
and imports
household sector to purchase goods from foreign countries. These exports
in thecircular flow are shown in Figure 2.4.

Exports & Transfer Payments Imports

Foreign
-> Imports -- - Sector
Transfer
Payments
Government Government
Purchases Sector Taxes

Services
Social
Capital Saving Transfer
Payments
Investment
Market
laxes
Consumption
Expenditure

Product
Market

Business Sector Household Sector

Factor
Market

Income
Payments

Fig.2.4

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 Take the inflows and outflows of the household, business and government
sectors in relation to the foreign sector. The household sector buys goods imported
from abroad and makes payment for them which is a leakage from the circular flow.
The households may receive transfer payments from the foreign sector for the services
rendered by them in foreign countries.
On the other hand. the business sector exports goods to foreign countries and its
services
receipts are an injection in the circular flow. Similarly. there are many
banking,
rendered by business firms to foreign countries such as shipping, insurance,
They also receive royalties,
etc., for which they receive payments from abroad.
in foreign countries. On the
interests, dividends, profits, etc. for investments made
to the foreign sector for imports of
other hand, the business sector makes payments
consumer goods, and services from abroad.
capital goods, machinery, raw materials,
These are the leakages from the circular flow.
export and import goods and
Like the business sector, modern government also
countries. For all exports of goods, the
services, and lend to and borrow from foreign
Similarly, the government receives
government receives payments from abroad.
country as tourists and for receiving
payments from foreigners when they visit the
education, etc. and also when the
government provides shipping, insurance and
state-owned agencies. It also receives
banking services to foreigners through the
abroad. These are injections
royalties, interest, dividends etc. for investments made
payments made for the purchase
into the circular flow. On other hand, the leakages are
of goods and services to foreigners.
with saving,
Figure 2,4 shows the circular flow of the four-sector open economy
flow on the right hand side of the
taxes and imports shown as leakages from the circular
as injections into the circular
figure, and investment, government purchases and exports
transfer payments have
flow on the left side of the figure. Further, imports, exports and
household, the business and the
been shown to arise from the three domestic sectors-the
sector which is also
government. These outflows and inflows pass through the foreign
called the "Balance of Payments Sector".
the balance of
If exports exceed imports, the economy has a surplus in
payments.
payments. And if imports exceed exports, it has a deficit in the balance of

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2.5. Revision Points
supply ol
Two Sector : Means house hold sector. and firm sector. Household sector
the factors of production and it
factors, to the firm sector. The firm sector received
provide goods and services to the households sector.
balanced
includes Government sector. The Government sector
Three-Sector: It
way of taxation.
household sector as well as firms sectors by the
sector involved in import and export activities. It
Four-Sector: Adding Foreign
balanced the economy tocontrol the leakages.
foreign trade plays an important
Economy : The economy is an open one where
Open economy.
inflows into the
role. Exports are an injection or economic activities. the
Government involved and to control all the
Closed Economy: business
requiremnents of goods of all types from the
government purchases all its firms in order to encourage
their
makes transfer payments to
sector, gives subsidies and circular flow.
government expenditures are injections into the
production. These
2.6. Intext questions
economy
money income in a closed
1. Explain circular flow of
money income in a open economny
2. Explain circular flow of
income
the circular flow of money
3. Discuss the importance of
2.8. Key Words
Four-Sector, Open Economy, Closed Economy.
Two Sector, Three-Sector,

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But in the long run, exports of an economy must balance its imports. This is achieved
by the foreign trade policies adopted by the economy.
The whole analysis can be shown in simple equations:
Y=C+1+G ...(1)
goods and services, C for consumption
Where Y represents the production of
and Gfor government expenditure
expenditure, I investment level in the economy
respectively.
expenditure
introduce taxation in the model to equate the government
Now we
Therefore,Y =C+S+T...(2)
Where S is saving T is taxation.

By equating (1) and (2), we get.

C+IHG-C +S+T

IHG-S+T
investment into domestic
foreign sector, we divide
With the introduction of the
(I) and get
investment (Id) and foreign investment
LË +lht G=S+T
But I,= X-M

Where X is exports and M is imports

.:Id +(X-M) + G= S+T

Id + (X-M) = S+ (T-G)
condition in the circular flow of income
The equation shows the equilibrium
and expenditure.
2.3.6 Importance of the Circular Flow
the economy. We
The concept of the circular flow gives a clear-cut picture of
efficiently or whether there is any
can know whether the economy is working
disturbance in its smooth functioning.
It is with the help of circular flow that the problems of disequilibrium and the
restoration of equilibrium can be studied.

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 The role of leakages enables us to study their effects on the national economy.
For example, imports are a leakage out of the circular flow of income because they are
payments made to a foreign country. To stop this leakage, government should adopt
appropriate measures. Soas to increase exports and decrease imports.
Similarly, saving is a leakage out of the spending stream. This depresses the
circular flow of income. On the other hand, consumption expenditures are inflows. In
leakages exceed inflows, total spending is smaller than output. As a result, income and
employment tend to decline over a period of time. On the other hand, if inflows exceed
and
leakages, the spending stream is enlarged in the circular flow. This causes incone
employment to rise in the next period.
policy to
The study of circular flow also highlights the importance of monetary
Figure 2.2 shows
bring about the equality of saving and investment in the economy.
comes about through the credit or
that the equality between saving and investment
capital market. The credit market itself is controlled by
the government through
or investment exceeds saving,
monetary policy. When saving exceeds investment
investment spending. This is how
money and credit policies help to stimulate or retard
a fall or rise in prices is also controlled.
expenditure points toward the
Similarly, the circular flow of income and
equilibrium desired saving
importance of fiscal policy. For national income to be in
government spending (I+G). S+T
plus taxes (S+T) must equal desired investment plus
offset by injections of I+G
represent leakages from the spending stream which must be
into the incomne stream. If S+T exceeds I+G government
should adopt such fiscal
and expenditure
measures as reduction in taxes and spending more itself. On the nue
Thus the circular flow of income and
by encouraging saving and tax revenue.
expenditure tells us about the importance of compensatory fiscal policy.
2.4. Summary
The above text clearly explained about the circular flow of money income in a
twosectors (viz. household and firm) economy. Followed by the circular money flow
with savings and investment. Further it analysed the circular income flow in athree
sector closed economy i.e adding government sector. Finally, it comprised the circular
flow of money income in a four sector open economy i.e adding foreign sector.

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