CIRCULAR FLOW OF

ECONOMIC ACTIVITY

Overview

IntroductionThe two sector modelThe three sector modelThe four sector model

Introduction

In economics, the term circular flow of income or circular flow of economic activity refers to a simple economic model which describes the circulation/flow of income between producers and consumers

In the circular flow model, producer and consumer are referred to as "firms" and "households" respectively

Basic terms

In the present mixed economic system we find three basic

economic units.

Households Firms/Business Government Foreign market

Households:

It is a person or a group of people that share their income.

The members of households have two functions: they supply different factors of productionmembers of household also work as consumers

Firms:

An organization that produces goods and services for sale.

Regarded as the economic units whose main objective is to

maximize profit in the production process. The three main

functions are as follows:• Produce goods and services and supply them in the

market.• Firms purchase inputs or raw materials from households

to use them in the production process.

Government:

Just like households and firms the government also earns incomes and makes expenses. Two major functions played are:• Government earns revenue either from tax or non-tax

sources both from households and firms.

Government provides essential public services such as maintenance of law and order, defense services, judiciary etc

Foreign Market:

It consists of two kinds of international economic

transactions i.e. export and import of goods and services

and inflow and outflow of capital.

Financial Institution : consists of banks and non-bank intermediaries who

engage in the borrowing (savings from households) and lending of money.

the leakage that financial institutions provide in the economy is the option for households to save their money.

Two Sector Model

Assumptions

Households: To own all the factors of production To consume all final goods and services Their income consists of wages, rent, interest and profits

Business firms: To hire factors of production from households Produce and sell goods and services goods to the

households No corporate saving

Factor Markets:Flow of factors like land, labor, capital and organization

is

observed from households to firms and in return they

receive factor income like rent, wages, interest and profits

from firms.

Product Markets: These transactions show money flow from households

to

firm. Households purchase consumer goods and services

from firms and in exchange they make payments to firms.

Two Sector Model

FACTOR PAYMENTS = HOUSEHOLD INCOMES and

HOUSEHOLD EXPENDITURE= TOTAL RECEIPTS OF THE FIRM

So HOUSEHOLD INCOMES = FACTOR PAYMENTS = MONEY VALUE OF OUTPUT

Effects of Withdrawal and Injections

Withdrawals : an amount set aside by the households

and/or by the firms, not to be spent on the goods and

services over a period of time. It is not a saving rather it

reduces the volume of the circular flow.

Injections : the amount that is spent by the households

and/or firms in addition to their current incomes

generated within the regular economy. It increase the

size of the flow

Three Sector Model

Three Sector Model

Introduction

Three sector model is created by adding the Government sector to the Two sector model

Three kinds of monetary flows between the government and the rest of the economy i.e.

1)direct taxes on both households and firms

2)government expenditure

3)transfer payments and subsidies

Government spends a part of its tax revenue as ‘factor payments’ to the households and a part in the form of transfer payments as pension and food subsidy etc

Four Sector Model

Export/ Import Market

Financial Institutio

nsGovernment

Four sector model

Introduction

This circular flow of model shows the four macroeconomic

sectors of the economy i.e.

household, business firm, government, and foreign. These four sectors capture four fundamental

macroeconomic functions and their expenditures are

combined together to purchase the economy's total

production.

Assumptions: To introduce the financial market first and assumes

household saves in the financial market.

There are no inter-households borrowing.

If the households save a part of their income in the financial market (such as banks, insurance companies, stock market etc), this reduces the expenditure of Household on goods and services

Ultimately reduces the flow of money/income of the economy. So saving known as the leakage of the economy

Again the business firms borrow from the financial markets for investment in the capital goods (such as machineries, factories, tools, instruments etc)

This ultimately increases the productive capacity of the business firm. So investments are known as the injection for the economy

Through this investment expenditure the saving of the households deposited in the financial market are again bought into the expenditure stream and circular flow of economic activity continued

Government Sector:

Government purchases goods and services just as households and firms do.

It also borrows from the financial market.

Also collects money from firm and household through taxes.

This money of the Government again spends in the economy in the form of expenditure on the capital goods and infrastructure (such as highways, power, communication etc).

Foreign Market(export and import):

Goods and services produced within the domestic territory which are sold to the foreigners are called exports.

On the other hand, purchases of foreign made goods and services by domestic households are called as imports.

Here we assume that only business forms can interact with the foreign countries and dealt with the export and import of the country. Money goes through import from the economy again returned back to the country through export activities

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Presented By:

Uma LakhotiaChitrak PalRaashi

ChoudharyBidisha GhoshPooja ChatterjiShilpi Dutta