Circular Flow of Income

Circular flow
The circular flow means the unending flow of production
of goods and services, income, and expenditure in an
economy. It shows the redistribution of income in a circular
manner between the production unit and households.
These are land, labour, capital, and entrepreneurship.
● The payment for the contribution made by fixed
natural resources (called land) is known as rent.
● The payment for the contribution made by a human
worker is known as wage.
● The payment for the contribution made by capital is
known as interest.
● The payment for the contribution made by
entrepreneurship is known as profit.
Real flow and money flow
Real flow: The term real flow means the flow of factor services from households to
firms. Similarly, the flow of goods and services from firms to households.

Money flow: The money flow refers to the flow of factor payments from firms to
households for factor services. Similarly, the flow of consumption expenditure from
households to firms for the purchase of goods and services manufactured by the firms
Three different phases in the circular flow of income
● Generation phase: In this phase, the firm manufactures the goods and
services with the assistance of factor services.
● Distribution phase: This phase involves the flow of factor income, which
comprises rent, interests, wages, and profit from the firm to the
household.
● Disposition phase: Here, the income collected by the factors of
production is used on the goods and services manufactured by a firm.
Sectors in circular flow
1) Households sector ( consuming sector)
2) Firms sector ( producing sector)
3) Government sector
4) Rest of the world sector ( foreign
sector/external sector)
Two Sector Economy with financial market i.e bank
Two Sectors economy ( Private closed economy)
The circular flow of income is an economic model that reflects how money or income
flows through the different sectors of the economy. A simple economy assumes that there
exist only two sectors, i.e., Households and Firms. Households are consumers of goods
and services and the owners of the factors of production (land labour, capital, and
enterprise). However, the firm sector produces goods and services and sells them to
households.
In the circular flow of income (two-sector economy), there is an exchange of goods and
services between the two players i.e., the firms and households, which leads to a certain
flow of money in the economy. Households provide the firms with the factors of
production, namely Land (Natural Resources), Labor, Capital, and Enterprise that
generates goods and services, and consumers spend their income on the consumption of
these goods and services. The firms then make factor payments to households in the form
of rent, wages, interest, and profit. This flow of goods and services and factors payments
between firms and households reflects the circular flow of money in an economy.
In the circular flow of an economy in a two-sector model without the financial
market(bank), it is assumed that no savings are made in the economy. It means
that the households spend their entire income on the purchase of goods and
services and every firm spends all the receipts from the sale of goods and services
to make factor payments.
However, it does not happen in the actual world, i.e., households do not spend
their entire income on the consumption of goods and services. Instead, they save
a part of their income for the future. In the same way, the firms save some part of
their receipts for the expansion of business or various other reasons. Besides, the
firms also borrow money from outside to finance their expansion plans. All of
these savings and borrowings happening in the economy are channelised through
the financial market. Therefore, in a two-sector economy, the savings made by
households accumulated in the financial market are used by the firms for
investment purposes.
Three sectors economy ( closed economy)
The government also plays a crucial role in the economic development of a
country. Therefore, the circular flow of income in a three-sector economy
includes households, firms, and the government sector. The government of a
country acts as both a firm and a consumer. As a firm or producer, the
government produces goods and services for the economy. However, as a
consumer, it spends money on the consumption of goods and services produced
by the firms. Besides the flows of circular income in the two-sector economy with
a financial market, the additional flows due to the inclusion of the Government
are:
1. Between Households and Government: The money from the government to
households flows in an economy in two forms. First, in the form of transfer
payments, such as old age pensions, scholarships, etc. Second, in the form of
factor payments for hiring factor services of the households. This money flows
back from households to the government in the form of direct taxes, such as
interest tax, income tax, etc.
2. Between Firms and Government: The money from firms to the government
flows in an economy in the form of direct and indirect taxes. However, the money
from the government to the firms flows into an economy in the form of subsidies.
In this case, the government grants subsidies to the firms and makes payments to
the firms for the purchase of goods and services produced by them.
The financial market also plays an important role in a three-sector economy, as
the government saves a part of their earned income and deposits the same in the
financial market. Besides, the government also borrows money from the financial
market so it can meet its expenditures.
Role of Government Sector in an Economy
● The Government Sector of an economy performs the following activities:
● It collects taxes from the households and firms.
● It makes the payment for the purchase of goods and services from the firms.
● It also makes transfer payments to the households and provides the firms
with subsidies.
● Lastly, Government saves and borrows money by taking help from the
financial market.
Four sector economy ( open economy)
Besides households, firms, and the government, the foreign sector also plays a crucial
role in an economy. Therefore, the circular flow in a four-sector economy consists of
households, firms, government, and the foreign sector. Money flows in each of these
sectors are as follows:

1) Household Sector: The household sector of an economy provides factor services

to the firms, government, and the foreign sector for which it received factor
payments in return. Besides factor payments, the households also receive transfer
payments like old age pensions, scholarships, etc., from the government and
foreign sector. The household sector spends its earned income on Payments for
goods and services purchased from firms, payments for imports, and tax
payments to the government.
2. Firms: The firms receive revenue for the sale of goods and services from the government,
households, and foreign sectors. They also receive subsidies from the government to produce goods
and services. Besides, the firms make payments for taxes to the government, factor services to the
households, and imports to the foreign sector.

3. Government: The government receives revenue for the sale of goods and services, fees, taxes,
etc., from the firms, households, and the foreign sector. It also makes factor payments to households
and spends its revenue on transfer payments and subsidies.

4. Foreign Sector: The foreign sector receives revenue for the export of goods and services from
firms, households, and the government. It also makes payments to firms and the government for the
import of goods and services, and households for the factor services.

The financial market also plays an important role in a four-sector economy as the savings made by
the households, firms, and the government gets accumulated here and this money is invested by the
financial market in the form of loans to firms, households, and the government. The inflows of
money in the financial market in a four-sector economy are equal to the outflows of money, which
makes the circular flow of income continuous and complete.
Leakages and Injections
 Leakages (Contraction of circular flow)

It means to withdraw money from the circular flow of an economy. Leakage from the
circular flow of income of an economy happens when the firms and households save a
part of their incomes. Therefore, leakage or withdrawal is that part of the income of an
economy that does not pass through the circular flow of income, resulting in the
unavailability of that money for spending on the goods and services produced recently.
Thus, it can be said that leakages reduce the flow of income in an economy.
Examples: savings, taxes and imports
Two-Sector Economy (with Financial Market)= Savings
Two-Sector Economy (without Financial Market)= No Leakages
Three-Sector Economy= Savings + Taxes
Four-Sector Economy= Savings + Taxes + Imports
● Savings is that portion of the income of a firm or household that is not spent on
the purchase of goods and services or distributed as profits but is retained for the
future.
● Imports are the goods purchased by the residents of a country from foreign
countries, resulting in an outflow of income from the economy.
● Tax is the amount paid to the government by firms and households
Injection (Expansion of circular flow)
It means the addition or introduction of income to the circular flow of an economy.
Injections into the circular flow of income are a result of money borrowed by
households and firms from different external sources, like financial institutions.
However, this additional income does not result in an immediate expenditure. Therefore,
injections increase the flow of income in an economy.

Examples: investment, government expenditure and exports

Two-Sector Economy (with Financial Market)= Investment

Two-Sector Economy (without Financial Market)= No Injection

Three-Sector Economy =Investment + Government Expenditure

Four-Sector Economy= Investment + Government Expenditure + Exports

● Investment is the part of the income which is used for the purchase of a capital
asset. An investment generates a return in the future. In other words, investment
is the expense made by a firm on capital expansion.
● Exports are the goods sold by firms to foreign countries, resulting in an inflow
of income into the economy.
● Government Expenditure is the total consumption expenditure made by the
government of a country on the purchase of goods and services, transfer
payments to the households, and providing subsidies to firms.