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Circular Flow of Income

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Circular Flow of Income

This is a simple economic model which describes

the flow of income between producers and

consumers (Firms & House holds) in a circular

mode It highlights the interdependence of goods markets

and factor markets

It is the relationship between production and

consumption

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Householdsa household is defined as a small

group of persons who share thesame living accommodation, who

pool their income and wealth and

who consume certain types of goods

and services collectively (mainlyhousing and food)

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AssumptionsThe basic circular flow of income model consistsof six assumptions:

The economy consists of two sectors: households and firms.

Households spend all of their income (Y) on

goods and services or consumption (C). There isno saving (S).

All output(O) produced by firms is purchased byhouseholds through their expenditure (E).

There is no financial sector.

There is no government sector.

There is no external sector.

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The circle of money flowing through theeconomy is as follows: total income is spent(with the exception of "leakages" such asconsumer saving)

while that expenditure allows the sale ofgoods and services, which in turn allows thepayment of income (such as wages andsalaries).

Expenditure based on borrowings andexisting wealth

i.e., "injections" such asfixed investment can add to total spending.

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Labor and other factors of production are sold on

resource market and goods and services are sold

on the product market

If there are no leakages it would be Y=E=O

Leakages are savings, Taxes, Imports

Injections are Investment, Govt. spending, Exports

Although leakages may eventually finance theinjections, they do not cause them

So in an open economy there can be three

gaps/imbalances

i) investment-savingsii) Fiscal deficit/surplus

iii) current Account(BOP) deficit/surplus

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Factor

payments

Consumption of

domestically

produced goods

and services (Cd)

The circular flow of income

Firms

Households9

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Factor

payments

Consumption of

domestically

produced goods

and services (Cd)

Investment (I)

Government

expenditure (G)

Export

expenditure (X)

Financial

system,

(BANKS,

etc.)

Net

saving (S)

GOV.

Nettaxes (T)

ABROAD

Import

expenditure (M)

The circular flow of income

LEAKAGES

INJECTIONS

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5 sector model of the economy

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The interdependence of goods and factor

markets

Q1

P1

QF2

PF2

Q2

P2PF1

QF1

D2D2

P

Q

P

Q

Factor

services

Goods

GoodsFactor

services

S S

D1 D1

(1)

Consumerdemand

(4)

Factor

supply

(3)

Factor

demand

(2)

Producer

supply

OO

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