Circular Flow of Income
Introduction - What is the Circular Flow of Income?
A model that illustrates the continuous movement of money,
goods, and services within an economy.
Shows the fundamental relationships and interactions between
different economic sectors.
Helps to understand how income is generated, distributed, and
spent.
Forms the basis for macroeconomic analysis, including national
income accounting.
Key Economic Agents (Sectors)
Households:
Own the factors of production (labor, land, capital,
entrepreneurship).
Supply these factors to firms.
Receive income (wages, rent, interest, profit).
Consume goods and services.
Firms (Businesses):
Use factors of production to produce goods and services.
Sell goods and services to households, other firms, and the
government.
Pay income to households for their factors of production.
(Optional) Government:
Collects taxes from households and firms (leakage).
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Spends on public goods and services, infrastructure, and
social welfare (injection).
Plays a role in regulating the economy.
(Optional) Foreign Sector (Rest of the World):
Involved in international trade (exports and imports).
Exports are an injection into the domestic economy.
Imports are a leakage from the domestic economy.
(Optional) Financial Sector:
Facilitates saving and investment.
Households save money, which flows into the financial
sector.
Firms borrow money for investment from the financial
sector.
The Two-Sector Model (Simple Economy)
Focuses on the interaction between households and firms.
Flow 1: Real Flow:
Households supply factors of production to firms.
Firms produce and supply goods and services to households.
Flow 2: Money Flow:
Firms pay income (wages, rent, interest, profit) to
households for their factors.
Households spend their income on goods and services
produced by firms (consumption expenditure).
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Fig.1
Assumptions of the Two-Sector Model
Closed Economy: No government or foreign sectors
No Savings: Households spend all their income on
consumption.
No Investment: Firms do not invest; all output is consumed
by households.
(Often implied) All output produced is purchased.
The Three-Sector Model (Including
Government)
Adds the government sector to the two-sector model.
Leakage: Taxes (T) flow from households and firms to the
government.
Injection: Government spending (G) flows into firms (for
goods and services) and households (e.g., salaries,
transfers).
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The circular flow now involves households, firms, and the
government interacting through taxes and government
spending.
The Four-Sector Model (Open Economy)
Includes the foreign sector (rest of the world).
Leakage: Imports (M) - domestic spending on foreign goods
and services. Money flows out of the domestic economy.
Injection: Exports (X) - foreign spending on domestic goods
and services. Money flows into the domestic economy.
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The circular flow now involves households, firms, the government, and
the foreign sector.
Fig.2
Phases of the Circular Flow of Income
Generation (Production Phase): Firms produce goods and
services by using factors of production supplied by
households.
Distribution (Income Phase): Firms distribute income (factor
payments) to households in return for their factors of
production.
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Disposition (Expenditure Phase): Households spend their
income on the goods and services produced by firms,
completing the cycle.
Types of Flows
Real Flow (Physical Flow): The movement of goods and services and
factors of production. (E.g., labor from households to firms, goods from
* firms to households).
Money Flow (Nominal Flow): The corresponding movement of money
payments. (E.g., wages from firms to households, consumption
expenditure from households to firms).
These two flows move in opposite directions and are interdependent.
Leakages and Injections
Leakages (Withdrawals): Flows of money that leave the circular
flow, reducing the overall expenditure and income in the economy.
Examples:
Savings (S): Income not spent by households.
Taxes (T): Payments to the government.
Imports (M): Spending on foreign goods and services.
Injections: Flows of money that enter the circular flow, increasing the
overall expenditure and income in the economy. Examples:
Investment (I): Spending by firms on capital goods.
Government Spending (G): Government expenditure on
goods and services.
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Exports (X): Foreign spending on domestic goods and
services.
Equilibrium in the Circular Flow
The economy is in equilibrium when total leakages equal total
injections.
In a simple model: Savings = Investment (S = I)
In a three-sector model: Savings + Taxes = Investment +
Government Spending (S + T = I + G)
In a four-sector model: Savings + Taxes + Imports =
Investment + Government Spending + Exports (S + T + M = I
+ G + X)
Imbalances between leakages and injections can lead to
economic expansion or contraction.
Injections > Leakages: Economic growth, increased national
income.
Leakages > Injections: Economic contraction, decreased
national income.
Importance of the Circular Flow of Income
Provides a simplified framework for understanding
macroeconomic relationships.
Helps to visualize how different sectors of the economy are
interconnected.
Illustrates the determinants of national income and
expenditure.
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Explains how injections and leakages affect the level of
economic activity.
Forms the basis for more complex macroeconomic models.
Limitations of the Circular Flow Model
Simplification: It is a highly simplified representation of a
complex economy.
Aggregation: Treats all households and firms as homogenous
groups.
Static: Often presented as a static model, not fully capturing
dynamic changes.
Ignores complexities: Doesn't fully account for factors like
market imperfections, income inequality, and technological
change
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