Ch - Circular flow of income
Meaning of macroeconomics: macroeconomics is that part of
economics theory which studies the behaviour of aggregates of
the economy as a whole. For example national income, aggregate
output, aggregate consumption etc .
Difference between microeconomics and macroeconomics
# Circular flow of income
It refers to cycle of generation of income in the production
process, it's distribution among the factor of production and finally,
it's circulation from household to firm in the form of consumption
expenditure on goods and services produced by them.
Phases of circular flow of income : there are three different
phases (generation, distribution, disposition) in circular flow of
income .
1) Generation phase : in this phase firm produce goods and
services with the help of factor services .
2) Distribution phase : this phase involve the flow of factor
income ( rent , wages, interest profit) from firm to household.
3) Disposition phase : in this phase the income received by
factor of production is spend on goods and services
produced by firm.
In this way, income generated in production units reach back to
production unit and makes the circular flow complete.
Stock and flow
The concept of stock and flow are used frequently in
macroeconomics. Some of the macro variable related to stock,
while other related to flow. Therefore it is important to understand
their meaning so that variable can be categorised as stock or
flow.
Stock : stock variables refers to that variables which is measured
at a particular point of time. For example stock of goods in
godown as on 31st March 2024 . It means stock variables are not
time dimensional. Some more example of stock variable are
national wealth, national capital, money supply etc.
Flow : flow variables refers to that variable, which is measured
over a period of time. For example production of goods during the
month of January 2024 , birth rate in year 2023, National income
in year 2023, are flow variables. The period of time could be a day
a week a year it means flow variable are time dimensional as they
are measured for a period of time.
Type of circular flow
There are two types of circular flows (1) Real flow (2) money flow
Real flow
Real flow refers to the flow of goods and services from household
to firm and the corresponding flow of goods and services from
firm to household.
It is also known as physical flow .
There is only exchange of goods and services between the two
sector without involvement of any money .
Money flow
Money flow refers to the flow of factor payment from firm to
household for their factor services and corresponding flow of
consumption expenditure from household to firm for purchase of
goods and services produced by the firm.
It is also known as Nominal flow
It involves exchange of money between two sector.
Four Sectors of the Economy
The major sectors in an economy according to the
macroeconomic point of view are:
1. Household Sector: It includes consumers of goods and
services and also the owners of factors of production. They
supply factors like land, labour, capital and entrepreneur and
receive income in return in the form of rent, wages, interest
and profit respectively.
2. Producing Sector (Firms): It includes all producing firms in
the economy. To produce goods and services, the firm hires
factors of production from the households.
Households consume goods and services to satisfy their wants
and firms produce goods and services to make a profit.
3. Government Sector: It acts in two capacities:
a. As a welfare agency, it is involved in
maintaining law and order, defence and other
services of public welfare.
b. As a producer, it produces goods and services
in public sector enterprises.
4 Foreign Sector (or External Sector or Rest of the
World Sector): This sector includes transactions with
the rest of the world. It is involved in export and import
of goods and flow of capital between the domestic
economy and other countries of the world.
CIRCULAR FLOW IN A SIMPLE ECONOMY (TWO-SECTOR
ECONOMY)
A simple economy assumes the existence of only two sectors, i.e.
household sector & firm sector.
1 Households are the owners of factors of production and consumers
of goods and services.
2 Firms produce goods and services and sell them to the households.
It is the simplest form of closed economy**, in which there is
no government sector and foreign trade.
In order to make our analysis simple, we take some
assumptions:
1. There are only 2 sectors in the economy: Households
and Firms. It means, there is no government and foreign
sector.
2. Household sector supplies factor services only to firms
and the firms hire factor services only from
households.
3. Firms produce goods and services and sell their entire
output to the households.
4. Households receive factor income for their services and
spend the entire amount On consumption of goods and
services.
5. There are no savings in the economy, i.e. neither the
households save from their incomes, nor the firm save
from their profit.
factor Services
Fig. 1.4
. The outer loop
of diagram shows the real flow, i.e. flow of factor services from households to firms and
corresponding flow of goods and services from firms to households.
• The inner loop shows the money flow ,i.e. flow of factor payments from firms to
households and the corresponding flow of consumption expenditure from households to
firms.
Leakages
Leakages refer to withdrawal of money from the circular flow. When households and
firms save a part of their incomes, it leads to a leakage from the circular flow of
income. Leakage or withdrawal refers to that part of income, which does not pass
through the circular flow of income. As a result, it is not available for spending on
currently produced goods and services. It means, leakages reduce the flow of Income.
Examples of Leakages in different types of Economies
4. Two-sector economy (without Financial Market) »» No Leakage
5. Two-sector economy (with Financial Market) »» Savings
6. Three-sector economy »» Savings + Taxes
7. Four-sector economy »» Savings + Taxes + Imports
Injections
Injection refers to the introduction of income into the circular flow. When households
and firms borrow money from external sources like financial institutions, it adds to their
income. Such additional income does not result in immediate expenditure. So,
injections increase the flow of income.
Examples of Injections in different types of Economies
4) Two-sector economy (without Financial Market) »» No Injection
5) Two-sector economy (with Financial Market) »» Investment
6) Three-sector economy »» Investment + Govt. Exp.
7) Four-sector economy »» Investment + Govt. Exp. + Exports
It must be noted that Equilibrium is achieved when Injections
are equal to Leakages.
Domestic territory ( Economic territory )
Domestic territory” refers to the economic area where a country’s
residents are considered to operate and where economic activity is
measured. It’s a broader concept than just the geographical boundaries,
encompassing ships, aircrafts, and even diplomatic missions of the
country in foreign lands.
It also includes:
1) Ships and aircrafts owned and operated by normal residents
between two or more countries. For example, planes operated
by Air India between Russia and Japan are part of the
domestic territory of India. Similarly, planes operated by
Singapore Airways between India and Japan are a part of the
domestic territory of Singapore.
2) Fishing vessels, oil and natural gas rigs and floating platforms
operated by the residents of a country in the international
waters where they have exclusive rights of operation. For
example, fishing boats operated by Indian fishermen in
international waters of Indian Ocean will be considered a part
of domestic territory of India.
3) Embassies, consulates and military establishments of a
country located abroad. For example, Indian Embassy in
Russia is a part of the domestic territory of India.
Normal Residents
Normal resident of a country refers to an individual or an institution
who ordinarily resides in the country and whose centre of economic
interest also lies in that country. Normal resident include both
individual and institutions.
‘Centre of Economic Interest’ implies two things:
1) The resident lives or is located within the Domestic Territory;
and
2) The resident carries out basic economic activities of earnings,
spending and accumulation from that location.
Following are not included under the category of Normal
residents:
1) Foreign tourists and visitors who visit a country for recreation,
holidays, medical treatment, study, sports, conferences, etc.
2) Foreign staff of Embassies, officials, diplomats and members
of the armed forces of a foreign country, located in the given
country.
3) International organisations like UNO, WHO, etc. are not
considered as normal residents of the country in which they
operate. They are treated as the normal residents of interna
tional area.
4) Employees of international organisations are considered as
residents of the countries to which they belong and not of the
international area. For example, an American working in UNO
office located in India will be treated as normal resident of
America.
5) Border workers who live near the international border and
cross the border on a regular basis to work in the other
country. They are treated as normal residents of the country
where they live, and not where they work.
Citizenship and Residentship
Citizenship
It is basically a legal concept based on the place of birth of the
person or some legal provisions allowing a person to become a
citizen. It means, Indian citizenship can arise in two ways:
1) When a person is born in India, he acquires automatic
citizenship of India.
2) A person born outside India applies for citizenship and Indian
Law allows him to become Indian Citizen.
Residentship
1) It is an economic concept based on the basic economic
activities performed by a person.
2) An individual is a normal resident of a country if he ordinarily
resides in the country for a period more than one year and his
centre of economic interest also lies in that country.
Factor income or transfer income
Factor income: factor income refers to income received by factor
of production for rendering factor services in the production
process.
1) It is received for providing factor services of land, labour,
capital and enterprise. As factor income is earned for
contributing to production process, it is a Bilateral Income.
2) Factor income of normal residents of a country is included in
the National Income.
3) Examples: Rent, wages, interest and profit.
4) It should be noted that Factor Incomes and Factor Payments
are the two sides of the same coin. It is factor income from the
viewpoint of the owners of factors of production, while it is
factor payment from the viewpoint of the producers of goods
and services.
*Factors of Production are the primary inputs, which are needed to
produce goods and services. They are broadly categorised under
four heads: (i) Land; (ii) Labour; (iii) Capital; and (iv) Entrepreneur.
Transfer Income
Transfer income refers to income received without rendering any
productive service in return. • It is a unilateral (one-sided) concept.
1) It is not included in National Income as it does not reflect any
production of goods and services.
2) It can be received either within the domestic territory of a
country or from abroad.
Examples: Old age pension, scholarship, unemployment
allowance, pocket money, etc.
Final Goods and Intermediate Goods
Final Goods
Final goods are those goods which are used either for consumption
or for investment.
Final Goods include:
Goods purchased by consumer household as they are meant for
final consumption (like milk purchased by household)
Goods purchased by firm for capital formation or investment (like
machinery purchased by a firm)
Intermediate Good
Intermediate good refers to those goods which are used either for
resale or for further production in the same year.
It includes
Goods purchase for resale ( like milk purchase by dairy shop)
Good used for further production. ( Like milk used for making
sweets)
Note : only final Goods are included in national income.
Consumption good or Capital good
Consumption goods : conception goods refers to those goods
which satisfy the want of the consumer directly.
Conception goods are of four types
1) Durable goods
2) Semi durable goods
3) Non durable good
4) Services
Capital Goods: capital goods are those final goods which help in
production of other goods and services. for example plant and
machinery equipment etc
