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Circular Flow of Income (2 Sector)

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11 views13 pages

Circular Flow of Income (2 Sector)

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adeolaatekoja
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CIRCULAR FLOW OF INCOME(2 SECTOR)

CIRCULAR FLOW OF INCOME


The circular flow model demonstrates how money
moves through society. Money flows from producers to
workers as wages and flows back to producers as
payment for products. In short, an economy is an
endless circular flow of money.

In an economy, money moves from producers to


workers as wages and then back from workers to
producers as workers spend money on products and
services.
CIRCULAR FLOW OF INCOME

The basic purpose of the circular flow model is to


understand how money moves within an economy. It
breaks the economy down into two primary players:
households and corporations.
Sectors of a Circular Flow Model

There are different types of circular flow models, each with a


different number of sectors it tracks. Below are the potential
sectors that could be included in a circular flow model. Each
sector within a circular flow model may be designated with a
capital letter often used to describe how to calculate GDP.
Household Sector
In a two-sector model, circular flow models start with
the household sector that engages in consumption spending
(C). Households contribute to an economy by working (giving
away time and labor) and by buying products (giving away
money). In return, households consume products and utilize
government programs.
Sectors of a Circular Flow Model

Business Sector
In a two-sector model, circular flow models also include
the business sector that produces the goods.
Businesses absorb a variety of production costs
including labor, materials, and overhead. As a result,
many companies are able to manufacture products that
benefit other parties.
3 Sectors of a Circular Flow Model.
3 Sectors of a Circular Flow Model.
• A three-sector model is one of the best ways to explain the flow of income
and expenditure in an economy. In a two-sector model, there are only two
sectors (households and businesses). But in the three-sector model, we
include the government as well. However, it is still all within the national
boundaries.

• And this model still is a closed economy where there are no foreign
transactions taken into account or assumed. Hence, another name for this
model is the closed economy model.

• So, this model introduces government purchases or expenditures and


taxation to our two-sector model theory of income determination. The
purchases, expenditures, and subsidies from the government inject more
money into the economy, while taxation takes out money from circulation.
3 Sectors of a Circular Flow Model.
Assumptions

The threes sector model makes the following assumptions:

1. This model assumes the existence of three sectors in the economy. And
those are households, businesses, and the government.

2. The intervention from the government remains in the form of taxation


and subsidies.

3. The market is perfectly competitive.

4. There is no international trade or any type of foreign transaction -grants,


loans, and other support.
3 Sectors of a Circular Flow Model.
To understand the flow of income and expenditure in this model, we need
to understand the flow of income and expenditure between each of these
three sectors.

• Let us first understand the structure and money flow between the
household sector and the government. The households earn income
from businesses and pay income tax on their earnings as well as pay other
taxes on consumption and other purchases to the government.

• In turn, the government uses this money from households and other
sources to offer several benefits and subsidies to the households. These
benefits include pension funds, education, health, sanitation, and more.
3 Sectors of a Circular Flow Model.
Similar way, let us now try to understand the to and fro flow between
businesses and the government. The flow between businesses and
government is similar to what we discussed between households and the
government. Businesses also need to pay income tax to the government on
their earnings and other taxes on their expenditure and transactions, exactly
like a household.

And in return, the government provides many benefits to businesses, such as


transfer payments, subsidies, and more. Also, the government buys goods
and services from businesses for its welfare activities. These are then used for
the benefit of the households.
Roles of Taxes
The tax payment that travels to the government treasuries
from the households and businesses is a direct
reduction/leakages in the circular flow of income and the total
output. Such leakages or diversions reduce the consumption
and savings of the households, as well as the investments and
production for the businesses.

However, the government uses those leakages to buy goods


and services from businesses and provide various welfare
services to households. This expenditure equals the amount of
taxes the government collects—such a flow of income and
expenditure results in equilibrium in the economy.
Circular Flow Model: Injection and Leakages.

Withdrawals (W) into Circular Flow of Income


Withdrawals are items that take money out of the
circular flow. This includes:
Savings (S) (money not used to finance consumption,
e.g. saved in a bank)
Imports (M) (money sent abroad to buy foreign
goods)
Taxes (T) (money collected by government, e.g.
income tax and VAT)
Circular Flow Model: Injection and Leakages.

Injections (J) into Circular Flow of Income


Spending that puts money into the circular flow of
income.
Investment (I). Money invested by firms into
purchasing capital stock.
Exports (X). Money coming from abroad to buy
domestically produced goods.
Government spending (G). Government welfare
benefits, spending on infrastructure.

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