Circular Flow of Income New1

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UNIT-1


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Circular Flow of Income


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Economy

What is an Economy?

Economy is an integrated system of production,

exchange and consumption.

People enter in to many economic transactionsof buying and selling goods and services to

carry out these functions.


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Economic transactions generate two

kinds of flows:

Product or Real flow ( flow of goods and

services) Money flow

Product flow consists of either factor

flow i.e. flow of services or goods flow

Both product and money flows inopposite direction and in circular

fashion.


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Interdependence of goods and

factor markets

FIRMS

(suppliers of goods and services,

demanders of factor services)

HOUSEHOLDS

(demanders of goods and services,

suppliers of factor services)


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What sectors make up an

Economy?

Household Sector

Business sector or the Firms

Government Sector

Foreign or International Sector


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These 4 sectors combine to

form following 3 models:

2 Sector model including the households and

the firms.

3 Sector model including the households, firms

and the Government Sector.

4 Sector model including the households, firms,

Government and the Foreign Sector.


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Circular Flow of Income and

Expenditure in a 2 Sector Model

2 Sector model represents a closed private economy, an

unrealistic model.

Features of Households:

Owners of all factors of production.

Income consists of rent, wages, interest and profit. Consumers of all goods and services.

Spend their total income on consumption, if any par of

income is saved, it is invested in firms.

Features of Firms:

Own no resources of their own. They hire and use factors of production.

They produce and sell goods and services.

They do not save.


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2 Sector Model


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From the diagram, we can figure out :

,

Y FP

FP w r i pFP V M

Thus V Y M


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Withdrawals, Injections and

the size of flows

The magnitude of income and expenditureflows depends on the societys income andexpenditure: the larger the size of income, thelarger the size of flows and vice versa.

In reality, there are leakages (withdrawals) andadditions (injections) to the circular flow ofincome.

A withdrawal is the amount set aside by thehouseholds and firms and is not spent on

domestically produced goods and services.Thus, saving is a withdrawal.

It reduces the size of flows.


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When savings are spent in the form ofinvestment, it takes the shape of injections.

An injection is the amount that is spent byhouseholds and firms in addition to the income

generated with in the regular economy. Aninjection by the household is the expenditurethat they make in addition to what they receivefrom the firms as factor income.

The injection by the household may be in the

form of spending inherited savings, ownhoardings, or by borrowing and spending onconsumer goods.


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The injection by the firms is the expenditure

what they make in addition to what they receive

on selling goods and services. They inject

money by spending their past savings or by

borrowing from the outside.

Injections increase the size of flows.


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Withdrawals and injections in

circular flows


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The 2 sector model with

savings

In reality, households do save a part of their

income for investment.

Thus, role of financial sector comes in to

existence.

Financial sector includes banks and other

financial intermediaries that accept deposits and

invest it in the business sector.

Thus, household income consist of

consumption expenditure (C) and savings (S).


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C and S take different routes.

C flows directly to the firms.

S is routed through financial sector and becomeInvestment (I).


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3 sector model is formed by adding

Government sector to 2 sector model.

Depicts a more realistic economy.

The inclusion of Government sector involvesthe addition of 3 variable: direct taxes,

government spending on goods and services

and transfer payments to the circular flow.

Taxes are withdrawals as they reduce private

disposable income and therefore consumption

expenditure and savings.


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Government expenditure is an injection as it

increases aggregate demand in the form of

government purchases.

Transfer payment is an injection which adds to

the household income resulting in increase in

households demand for consumer goods and

services.


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Circular Flow in a 3 sector

model


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The magnitude of flows between the

households and the firms is reduced because a

part of households and firms income flows in

the form of direct and indirect taxes to the

government sector.

The government spends a part of their income

on wages, salaries and transfer payments to the

households and a part of it on purchases from

the firms and payment of subsidies. Thus, the money that flows from the household

and firms to the government in the form of

taxes flows back to these sectors in the form of

government expenditure.


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Is the Government tax Revenue

(T) always equal to Government

Expenditure (G)? It depends on government budgetary policy.

Balanced budget policy, G=T

Deficit budget policy, G > T. It implies net

injections to the economy. Surplus budget policy, G < T. it implies net

withdrawals from the economy.


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It represents an open economy with the

inclusion of Foreign Sector.

Foreign sector consists of two kinds of

international transactions:

Foreign trade i.e. export and import of goods and

services.

Inflow and outflow of capital


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Assumptions of 4 sector model

The external sector consists of export and import ofgoods and services.

The export and import of goods and non laborservices are made only by the firms.

The households exports only labor.

Export (X) makes goods and services flow outof the country and make money flow in to thecountry. Thus, export represents injections.

Imports (M) make inflow of goods andservices and flow of money out of the country.Thus, import represents withdrawals.


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If X> M, increases the magnitude of circular

flows.

If X


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Circular Flow of Income New1