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2
Unit

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Circular Flow of Income

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Two, Three and Four Sector Economy Model

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The Economy’s Income And

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Expenditure
 When judging whether the economy is doing well
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or poorly, it is natural to look at the total income

that everyone in the economy is earning.
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 For an economy as a whole, income must equal

expenditure because:
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 Every transaction has a buyer and a seller.

 Every rupee of spending by some buyer is a rupee of
income for some seller.

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The Three Interpretations

 The concept of circular flow of income has three
interpretations:
 it represents a total value of production,
 it represents a receipts total, and
 it represents an expenditure total.

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The Three Fold Identities

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 Because every expenditure is at the same time a

receipt, and as goods and services are valued at
market prices, we have three fold identities, namely,
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 that the value received equals the value paid equals

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the value of goods and services produced and sold.

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Circular Flow of Income

 Circular flow of income refers to flow of money income
or the flow of goods and services across different
sectors of an economy in a circular flow.

Types of Circular Flow

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Product Flow Income Flow
(Real Flow)

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(Monetary Flow)

Factor Flow Product/Goods Flow

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Significance of Circular Flow

 Circular flow of income is important due to the following reasons:
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 (a) Knowledge of Interdependence. Circular flow models help to

understand interdependence between different sectors of the
economy. For example producers and households.
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 (b) Size of National Income. The magnitude of circular flow

determines the size of national income. More the magnitude, more is
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the national income and vice versa.

 (c) Level of Economic Activity. Circular flow, through its
information or various macro variables, tells us about the level of
economic activities in an economy.
 (d) Injections and leakages. Circular flow gives us information or
injections like investment, government spending, exports and
leakages like saving, tax and imports.

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Circular Flow of Income in Two Sector

Economy - Assumption
 Households and firms do not save from their income
and profits.
 Government does not play any role in national
economy.
No taxes are collected and no expenditure made.

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

 There are no imports or exports of goods and services.

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Circular Flow of Income in Two Sector Economy

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Figure 1 The Circular-Flow Diagram

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MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods •Firms sell Goods and
and services •Households buy services
sold bought
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FIRMS HOUSEHOLDS
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•Produce and sell •Buy and consume

goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of rupees

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Circular Flow with Saving and Investment

 When households save, their expenditure will decline to
that extent.
 Money flow to the business will contract.
 Firms will hire few workers or reduce factor payments.
 This will lead to a fall in total income of households.

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 Thus, savings reduce flow of money expenditure to business

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and will cause a fall in economy’s total income.
 Therefore, savings is a leakage from the money expenditure
flow.

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Circular Flow with Saving and Investment

However, savings by households need not reduce
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aggregate spending and income.

 In a free market economy there exist a financial
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market.
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 All the savings comes to the financial market.

 Firms borrow from financial market for capital
expenditure and future capacity.
 Thus, the savings are brought into expenditure stream
as a result flow of spending does not decrease.

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Condition for Constancy of Circular Flow

 Planned savings must be equal to planned
investment.
 If planned investment falls short of planned
savings…

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 Expenditure, income, output and employment will
fall contracting the flow of money.

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 Stock of goods will increase, owing to deficiency in
demand.
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Condition for Constancy of Circular Flow

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 Consequently, smaller amount of goods will be

produced causing investment to fall.
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 The effect of fall in planned investment or planned

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savings is the same, a fall in income, output,

employment and prices.

 The flow of money will contract.

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Condition for Constancy of Circular Flow

 If the equality between planned savings and
investment is disturbed by increase in investment
demand, the result will be increase in income, output,
employment.

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 As a result the flow of money will expand.

 Thus, the flow of money income will continue at a

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constant level only when the condition of equality
between planned savings and investment is satisfied.

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Classical Economist vs. Keynes

 Classical economist believed that financial market
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provides a mechanism which coordinates the savings of

the households and the investment expenditure by
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firms.
Rate of interest is determined by savings and
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investment.
 If savings exceeds investment expenditure, rate of
interest falls.

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Classical Economist vs. Keynes

 At a lower rate, investment increases and both
becomes equal.
 If investment expenditure is greater than savings,
rate of interest will rise.

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 Higher rate of interest causes savings to increase

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and become equal to planned investment.

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Classical Economist vs. Keynes

 According to Keynes, however, in a free market
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economy investment is made by firms and savings by

households is done for different reasons, there is no
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guarantee that planned investment will be equal to

planned savings.
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 Thus, fluctuation in income, output and employment

are inevitable.
 The circular flow does not continue at a steady level
unless certain corrective and preventive steps are
taken by government to maintain stability.

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Saving-Investment Identity in Circular Flow

 In a simple economy, the value of output produced,
denoted by Y is equal to the value of output sold.
 The value of output sold is equal to sum of consumption
expenditure and investment expenditure, we have:
Y = C + I ………………………………. (i)

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 Increase in inventories is treated as part of actual

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investment.
 Thus, GNP is used either for consumption or for
investment.

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The planned or intended investment and savings often differ and affect circular flow.
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Saving-Investment Identity ...

The unsold output leads to the increase in inventories,
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and in national income accounting, increase in

inventories is treated as part of actual investment.
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 This may be considered as the firm selling the goods to

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themselves to add to their inventories.

 Thus, Gross National Product is used either for

consumption or for investment.

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Saving-Investment Identity …

 Since national income can be either consumed or saved, we

have:
Y = C + S …………………………… (ii)
 From the identities (i) and (ii) we get,
C + I = Y = C + S ………………………… (iii)
The left hand side of the identity, C + I = Y shows the

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
component of aggregate demand.

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 The right-hand side of the identity, Y = C + S shows the
allocation of NI to either consumption or savings.
 Thus, identity (iii) shows that the value of output produced
or sold is equal to the total income received.
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Saving-Investment Identity …
 Now subtracting the consumption (C) from both side of
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the identity (iii) we have

I=S
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 Thus, in two sector economy, investment is identically

equal to savings.
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Circular Flow in Three Sector Model

 The inclusion of government sector significantly affects
the overall economic situation.
 Total expenditure flow in the economy is now the sum of
consumption expenditure (C), investment expenditure
(I) and government expenditure (G), Thus,
Total Expenditure (E) = C + I + G ………………. (i)

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 Total income (Y) received is allocated to consumption,

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savings and taxes. Thus,
Y = C + S + T ……………………… (ii)

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Circular Flow in Three Sector Model

 Since expenditure made must be equal to income
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received (Y), from equation (i) and (ii), we have,

C + I + G = C + S + T ………………….. (iii)
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 Since C occurs on both sides of the equation and will

be cancelled out, we have
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I + G = S + T…………………… (iv)
 By rearranging we obtain,
G – T = S – I …………………….. (v)
 Equation (v) depicts what would be the consequence if
government budget is not balanced.

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Circular Flow in Three Sector Model

 If (G) is greater than tax revenues (T), the
government will have a deficit budget
 To finance the deficit, govt. will borrow from the
financial market.
 Then private investment (I) must be less than

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savings (S).
 Thus, govt. borrowings reduces private

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investment, i.e. govt. borrowing crowds out private
investment.

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Four Sector Model of Circular Flow

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 There are four agents that we will focus on when

constructing a model of the economy:
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 Households
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 Firms

 Government

 The Rest of the World

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Markets

 There are three markets that we focus on:

 The Factor Market

 The Goods Market

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 The Financial Market

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Four Sector Model of Circular Flow

Firms hire factors of production from households. The blue
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flow, Y, shows total income paid by firms to households.

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Four Sector Model of Circular Flow

Households buy consumer goods and services. The red
flow, C, shows consumption expenditures.

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Four Sector Model of Circular Flow

Households save, S, and pay taxes, T. Firms borrow
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some of what households save to finance their

investment.
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Four Sector Model of Circular Flow

Firms buy capital goods from other firms. The red flow
represents this investment expenditure by firms.

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Four Sector Model of Circular Flow

Governments buy goods and services, G, and borrow or
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repay debt if spending exceeds or is less than taxes.

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Four Sector Model of Circular Flow

The rest of the world buys goods and services from us, X, and
sells us goods and services, M—net exports are X - M

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Four Sector Model of Circular Flow

And the rest of the world borrows from us or lends to us
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depending on whether net exports are positive or negative.

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Four Sector Model of Circular Flow

The blue and red flows are the circular flow of expenditure
and income. The green flows are borrowing and lending.

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Four Sector Model of Circular Flow

The sum of the red flows equals the blue flow.
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Four Sector Model of Circular Flow

That is: Y = C + I + G + X - M

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Four Sector Model of Circular Flow

 Thus, in an open economy
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 National Income = C + I + G + Xn (X –M)

 Since National Income can be either consumed, saved or
paid as taxes, we have:
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 C + I + G + Xn = C + S + T
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 Since C is common on both side of the equation, we have:

 I + G +Xn = S + T
 The above equation shows that sum of private
investment, government expenditure and net exports is
equal to the sum of savings and tax revenue.

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Injection and Withdrawals

 Injection is an addition to the circular flow of income. It
increases the size of circular flow.
 Leakages are withdrawals from a circular flow of income.
It reduces the size of circular flow.
 For stability in the circular flow of income,

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Leakages = Injections ..... = denotes identity
or

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S+T+M =I+G+X
or
[Savings + Taxes + Imports] = [Investments + Govt. Purchases + Exports]
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rj
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