2ND SEM UNIT-1 Circular Flow of Income

Circular Flow of Income:
The modern economy is a monetary economy. In the modern economy, money is used in the process of exchange.
Money has facilitated the process of exchange. Money has facilitated the process of exchange and has removed the
difficulties of the barter system. Thus money acts as a medium of exchange. The households supply the economic
resources or factors to the productive firms and receive in return the payments in terms of money corresponding
to the flows of economic resources and the flows of goods and services. But each money flow is in opposite
direction to the real flow.
Circular Income Flow in a Two Sectors Economy:
Real flows include flow of resources,

goods and services. 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.
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.
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.
Page 1 of 4
Circular Money Flow with Saving and Investment:
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 come workers) or reduce the factor payments they make to the suppliers of factors such as workers. 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. The leakage is again injected in to the economy in the form of investment.
The Circular income Flow in a Three-Sector Closed Economy:
The circular flow of a two-sector model of an economy consists of the household and the business sector. To this
we add the government sector so as to make it a three-sector closed model of circular flow of income and
expenditure. For this, we add taxation and government purchases (or expenditure) in our presentation. Taxation is
a leakage from the circular flow.
First, take the circular flow between

the household sector and the
government sector. Taxes in the
form of personal income tax and
commodity taxes paid by the
household sector are outflows or
leakages from the circular flow. But
the government purchases the
services of the households, makes
transfer payments in the form of old
age pensions, employment relief,
sickness benefit, etc., and also
spends on them to provide certain
social services like education, health,
housing, water, parks and other
facilities. All such expenditures by
the government are injections into
the circular flow.
Next the circular flow between the business sector and the government sector. All types of taxes paid by the
business sector to the government are leakages from the circular flow. On the other hand, the government
purchases all its requirements of goods of all types from the business sector, gives subsidies and makes transfer
payments to firms in order to encourage their production. These government expenditures are injections into the
circular flow.
Now we take the household, business and government sectors together to show their inflows and outflows in the
circular flow. As already noted, taxation is a leakage from the circular flow. It tends to reduce consumption and
saving of the household sector. Reduced consumption, in turn, reduces the sales and incomes of the firms. On the
other hand, taxes on business firms tend to reduce their investment and production. The government offsets these
leakages by making purchases from the business sector and buying senses of the household sector equal to the
Page 2 of 4
amount of taxes. Thus total sales again equal production of firms. In this way, the circular flow of income and taxes
are leakages.
It can be seen that taxes flow out of the household and business sectors and go to the government. Now, the
government makes investment and for this purchases goods from firms and also factors of production from
households. Thus government purchases of goods and services are an injection in the circular flow of income, and
taxes are leakages.
If government purchases exceed net taxes the government will incur a deficit equal to the differences between the
two, i.e., government expenditure and taxes. The government finances its deficit by borrowing from the capital
market which receives funds from households in the form of saving. On the other hand, if net taxes exceed
government purchases the government will have a budget surplus. In this case the government reduces the public
debt and supplies funds to the capital market which are received by firms.
The Circular flow in a Four-Sector Open Economy (Adding Foreign Sector):
The circular flow of income and expenditure for a two-sector and three-sector model is the case of a closed
economy. But the actual economy is an open one where foreign trade plays an important role. Exports are an
injection or inflows into the economy. They create incomes for the domestic firms. When foreigners buy goods and
services produced by domestic firms, they are exports in the circular flow of income. On the other hand, imports
are leakages from the circular flow. They are expenditures incurred by the household sector to purchase goods
from foreign countries.
Take the inflows and outflows

of the household, business and
government sectors in relation
to the foreign sector. The
household sector buys goods
imported from abroad and
makes payment for them which
is a leakage from the circular
flow. The households may
receive transfer payments from
the foreign sector for the
services rendered by them in
foreign countries. On the other
hand, the business sector
exports goods to foreign
countries and its receipts are an
injection in the circular flow.
Similarly, there are many
services rendered by business
firms to foreign countries such
as shipping, insurance, banking,
etc., for which they receive payments from abroad. They also receive royalties, interests, dividends, profits, etc. for
investments made in foreign countries. On the other hand, the business sector makes payments to the foreign
sector for imports of capital goods, machinery, raw materials, consumer goods, and services from abroad. These
are the leakages from the circular flow.
Page 3 of 4
Like the business sector, modern government also export and import goods and services, and lend to and borrow
from foreign countries. For all exports of goods, the government receives payments from abroad. Similarly, the
government receives payments from foreigners when they visit the country as tourists and for receiving education,
etc. and also when the government provides shipping, insurance and banking services to foreigners through the
state-owned agencies. It also receives royalties, interest, dividends etc. for investments made abroad. These are
injections into the circular flow. On other hand, the leakages are payments made for the purchase of goods and
services to foreigners.
The circular flow of the four-sector open economy with saving, taxes and imports shown as leakages from the
circular flow on the right hand side of the figure, and investment, government purchases and exports as injections
into the circular flow on the left side of the figure. Further, imports, exports and transfer payments have been
shown to arise from the three domestic sectors-the household, the business and the government. These outflows
and inflows pass through the foreign sector which is also called the “Balance of Payments Sector”.
If exports exceed imports, the economy has a surplus in the balance of payments. And if imports exceed exports, it
has a deficit in the balance of payments. But in the long run, exports of an economy must balance its imports. This
is achieved by the foreign trade policies adopted by the economy.
Page 4 of 4

2ND SEM UNIT-1 Circular Flow of Income

Uploaded by

Copyright:

Available Formats

2ND SEM UNIT-1 Circular Flow of Income

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2ND SEM UNIT-1 Circular Flow of Income

Uploaded by

Copyright:

Available Formats

Circular Flow of Income:

Circular Income Flow in a Two Sectors Economy:

Real flows include flow of resources,

The Circular income Flow in a Three-Sector Closed Economy:

First, take the circular flow between

The Circular flow in a Four-Sector Open Economy (Adding Foreign Sector):

Take the inflows and outflows

You might also like