Circular flow of Income

• Two sector Economy:

• Households & Business Firms
• Three sector Economy:
• Households, Business Firms & Government
• Four sector Economy:
• Households, Business Firms , Government &
Foreign Countries
 Circular flow of Income
• Factors of production:
• Land
• Labor
• Capital
• Enterprise(organization)
• Payments of factors of production:
• Land(rent)
• Labor(wage)
• Capital (interest)
• Enterprise(profit)
 Circular flow of Income
• AD= C+I+G+(X-M), AD= aggregate demand
• C= Consumption (Household Sector)
• I= Investment(Business Firm sector)
• G= Govt. spending(Govt. Sector)
• X-M= Net Export( Here, X=export, M= Import)
• Calculating ways of Expenditure and Income:
• Y= C+I+G+(X-M) Expenditure
• Y= C+S+T Income
 Circular flow of income
• The circular flow of income is a way of
representing the flows of money between the
two main groups in society producers(firms)
and consumers(households). These flows are
the part of fundamental process of satisfying
human wants.
 National Income Accounting
Circular Flow of Income in a Two Sector Economy:
Sectors are:
• Households: Are the suppliers of Factors of Production i.e. Land, Labour,
Capital & organization or Entrepreneurship. Households creates Real Flows
to the Business Firm For Production of Goods and Services. Households
are the Receiver (Consumer) of Goods & Services produced by the
Business Firms
• Business Firms: Business firms provide Money Flows in terms of price for
the factors of production. That means they pay Wages for Labour,Rent for
Land, Interest for Capital and Profit for Entrepreneurial ability or
Organisation. Business Firms produce Goods and Services for the
Households for their consumption.
 National Income Accounting
Here we see that Money Flows from Business Firms to
Households as
Factors Payment then
Money Flows from Households to Business firm for
purchase/Consumption or receiving of Goods &
services produced by the Business Firms.
This is the Circular flow of Money or Income in between
the considered two sectors of an economy .
It is a Simplified Circular Flow of Income with an
assumption that all income which the households
receives they spend it on consumer goods and services.
 Two Sector Economy
• Circular flow of national income in two sector economy is based on the
following assumptions:-
• i) It is a closed economy.
• ii) The firm sell all what they produce.
• iii) Firms make factor payments to the household as rent, wages, interest
and profits.
• iv) Household do not save any part of their income.
• v) There are no govt. intervention in the economy.
 Circular flow of Income: Two Sector
Economy: Households & Business Firm

Circular flow of income for a simple two sector economy

 Circular flow of Income
Circular Income Flow in a Two Sector Economy:
• Real flows of resources, goods and services have
been shown in above Figure. 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.
 Circular flow of Income
• In the lower part of the figure, money flows from households to firms 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 firms 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 flow of money will continue indefinitely week by week and year by year. This is how the
economy functions. It may, however, be pointed out that this flow of money income will not always
remain the same in volume.
• In other words, 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 in volume, 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 prosperity when the level of national income is
quite high, the flow of money will be large.
• In order to make our analysis simple and to explain the central issues involved, we take many
assumptions. In the first place, we assume that neither the households save from their incomes, nor
the firms save from their profits. We further assume that the government does not play any part in
the national economy.
 Circular flow of Income
• In other words, the government does not receive any money from the people
by way of taxes, nor does the government spend any money on the goods and
services produced by the firms or on the resources and services supplied by the
households. Thirdly, we assume that the economy neither imports goods and
services, nor exports anything. In other words, in our above analysis we have
not taken into account the role of foreign trade. In fact we have explained
above the flow of money that occurs in the functioning of a closed economy
with no savings and no role of government.
• Circular Income Flow with Saving and Investment:
• In our above analysis of the circular flow of income we have assumed that all
income which the households receive, they spend it on consumer goods and
services. As a result, circular flow of money speeding and income remains
undiminished. We will now explain if households save a part of their income,
how their savings will affect money flows in the economy.
• When households save, their expenditure on goods and services will decline to
that extent and as a result money flow to the business firms will contract. With
reduced money receipts, firms will hire fewer workers (or lay off some
workers) or reduce the factor payments they make to the suppliers of factors
such as workers.
 Circular flow of Income

In a two sector Economy:

Expenditure, Y= C+I
Income, Y= C+S, Then , Exp= Income, C+I= C+S,
S(saving)=I(Investment)
 Circular flow of Income
• This will lead to the fall in total incomes of the households. Thus, savings
reduce the flow of money expenditure to the business firms and will cause
a fall in economy’s total income. Economists therefore call savings a
leakage from the money expenditure flow.

• But savings by households need not lead to reduced aggregate spending

and income if they find their way back into flow of expenditure. In free
market economies there exists a set of institutions such as banks, insurance
companies, financial houses, stock markets where households deposit their
savings. All these institutions together are called financial institutions or
financial market. We assume that all the savings of households come in the
financial market. We further assume that there are no inter-households
borrowings.
• It is business firms who borrow from the financial market for investment in
capital goods such as machines, factories, tools and instruments, trucks.
Firms spend on investment in order to expand their productive capacity in
future.
 Circular flow of Income
• Thus, through investment expenditure by borrowing the
savings of the households deposited in financial market,
are again brought into the expenditure stream and as a
result total flow of spending does not decrease. Circular
money flow with saving and investment is illustrated in
Fig.2 where in the middle part a box representing
financial market is drawn. Money flow of savings is
shown from the households towards the financial
market. Then flow of investment expenditure is shown
as borrowing by business firms from the financial
market.
 Circular flow of Income
• Condition for the Constancy of Circular Income Flow:
• Now the question arises what is the condition for the flow of money
income to continue at a steady level so that it makes possible the
production and subsequent flow of a given volume of goods and services at
constant prices. To explain this we have to introduce saving and investment
in the analysis of circular flow of income.
• Saving a part of income means it is not spent on consumer goods and
services. In other words, saving is withdrawal of some money from the
income flow. On the other hand, investment means some money is spent on
buying new capital goods to expand production capacity. In other words,
investment is injection of some money in circular flow of income.
• For the circular flow of income to continue unabated, the withdrawal of
money from the income stream by way of saving must equal injection of
money by way of investment expenditure. Therefore, planned savings must
be equal to planned investment if the constant money income flow in an
economy is to be obtained.
 Circular flow of Income
• Now, what will happen if planned investment expenditure falls short
of the planned savings? As a result of fall in planned investment
expenditure, income, output and employment will fall and therefore
the flow of money will contract.
• If the equality between planned savings and planned investment is
disturbed by increase in savings, then the immediate effect will be
that the stocks of goods lying in the shelves of the shops will
increase (as some of the goods will not be sold due to the fall in
consumption i.e., increase in savings). Owing to the deficiency of
demand for goods and the accumulation of stocks, retailers will
place small orders with the wholesalers. Consequently, smaller
amount of goods will be produced and therefore fewer capital goods
like machinery will be indeed with the result that fixed investment
will tend to fall.
 Circular flow of Income
• Thus the ultimate effect of either the fall in planned investment or the increase in
planned savings is the same, namely, the fall in income, output, employment and
prices with the result that the flow of money will contract.
• On the other hand, if the equality between planned savings and planned investment
is disturbed by the increase in investment demand, the result will be increase in
income, output and employment. Consequently, the flow of money income will
expand.
• It is thus clear from the above analysis that the flow of money income will continue
at a constant level only when the condition of equality between planned saving and
investment is satisfied. It was believed by classical economists that financial market
provides a mechanism which coordinates the savings of households and the
investment expenditure, by the firms. Rate of interest, which is the price for the use
of savings, is determined by saving and investment.
• If savings exceed investment expenditure, rate of interest falls so that, at a lower
rate of interest, investment increases and both become equal. On the contrary, if
investment expenditure is greater than savings, rate of interest will rise so that at a
higher rate of interest savings increase and become equal to planned investment
expenditure.
Three Sector Model of Circular Flow of
Income
The three-sector model adds the government sector to the
two-sector model. Thus, the three-sector model includes (1)
households, (2) firms, and (3) government. It excludes the
financial sector and the foreign sector. The government
sector consists of the economic activities of local, state and
federal governments. Flows from households and firms to
government are in the form of taxes. The income the
government receives flows to firms and households in the
form of subsidies, transfers, and purchases of goods and
services. Every payment has a corresponding receipt; that
is, every flow of money has a corresponding flow of goods
in the opposite direction. As a result, the aggregate
expenditure of the economy is identical to its aggregate
income, making a circular flow.
Circular flow of Income: Three Sector Economy :
Households, Firms & Government

In a three sector Economy: Exp.= C+I+G and Income, Y=C+S+T

Exp= Income, Then, C+I+G= C+S+T, I+G= S+T
 Four sector Economy
• The circular flow model in four sector economy
provides a realistic picture of the circular flow in an
economy. Four sector model studies the circular flow in
an open economy which comprises of the household
sector, business sector, government sector, and foreign
sector.
• The foreign sector has an important role in the
economy. When the domestic business firms export
goods and services to the foreign markets, injections
are made into the circular flow model. On the other
hand, when the domestic households, firms or the
government imports something from the foreign sector,
leakage occurs in the circular flow model.
 Circular flow of Income

Circular flow of income for an open Economy

In a four sector Economy: Exp= C+I+G+(X-M) and Income= C+S+T
G+(X-M)= S+T
 Four sector economy
• The circular flow of income in four sector
economy can be explained by the flowing
diagram:
• From the viewpoint of the circular flow of
income, each sector has dual roles to play in
the economy; while a sector receives certain
payments from other sectors, it pays back to
those sectors as well.