The Circular Flow of Income

The Circular
Flow of Income
The Circular flow of Income
The amount of income generated in a
given economy within a period of time
(national income) can be viewed from three
perspectives. These are:
1.Income,-total sum of all income received within a particular period
2.Product, -the total good and services produced within a particular period
3.Expenditure.
 The circular flow of income and product is used to show
diagrammatically, the equivalence between the income
approach and the product approach in measuring gross
national product (GNP).
 In analysing the circular flow of income, there are three
scenarios:
1. A simple and closed economy with no government
and external transactions, i.e., two-sector economy;
2. A mixed and open economy with savings, investment
and government activity, i.e., three-sector economy;
3. A mixed and open economy with savings, investment,
government activity and external trade, i.e., four-sector
economy.
Circular Flow of Income
in a Two-Sector
Economy:
FIRMS
(suppliers of goods and services,
demanders of factor services)
HOUSEHOLDS
(demanders of goods and services,
suppliers of factor services)
Circular Flow of Income in a Two-
Sector Economy:
 According to circular flow of income in a two-
sector economy, there are only two sectors of
the economy, i.e.,
1. Household sector
2. Business sector.
Government does not exist (no public
expenditure, no taxes, no subsidies, no social
security contribution, etc. The economy is a
closed one, having no international trade
relations. )
(i) Household Sector:
 the sole buyer of goods and services,

 the sole supplier of factors of production, i.e., land, labour, capital
and organisation. It spends its entire income on the purchase of
goods and services produced by the business sector.
 there are no savings and investments.
(ii) Business Sector:
 the sole producer and supplier of goods and services.

 The business sector generates its revenue by selling goods and
services to the household sector.
 The business sector sells the entire output to households.
 Therefore, there is no existence of inventories.
 In a two-sector economy, production and sales are thus equal.. The
basic identities of the two-sector economy are as under
Y=C
Where Y is Income
C is Consumption
Circular Flow of Income in a
Two-Sector Economy (Saving
Economy):
Circular Flow of Income in a Two-Sector
Economy (Saving Economy):
 In a two-sector macro-economy, if there is saving by the
household sector out of its income, the goods of the
business sector will remain unsold by the amount of
savings.
 Production - reduced & income of the households - fall.
 In case the savings of the households is loaned to the
business sector for capital expansion, then the gap
created in income flow will be filled by investment.
 Through investment, the equilibrium level between
income and output is maintained at the original level. It
is illustrated in the following figure:
 The equilibrium condition for two-sector
economy with saving is as follows:
Y = C + S or Y = C + I or C + S = C + I or S = I
Where
Y is Income
C is Consumption
S is Saving
I is Investment
Three-Sector Economy
Three-Sector Economy
 Additional sector is the government.
 Two-sector economy is a hypothetical
economy, whereas the three-sector
economy is much more realistic.
 The inclusion of the government sector is
very essential in measuring national
income.
 The following figure illustrates three-
sector economy:
 Personal income after tax or disposable income - received
by households from business sector and government sector
is used to purchase goods and services and makes up
consumption expenditure (or C).
 Total spending on goods and services is known as
‘aggregate demand’.
 The total market value of output produced and sold is also
known as ‘aggregate supply’.
 To measure aggregate demand in a closed economy, we
simply add consumption spending (C), investment
spending (I) and government spending (G). Therefore:
Y=C+I+G
Where Y is Income,
C is Consumption,
I is Investment,
G is Government Spending.
 government spending (G) = buying of labour from
factor market,+ buying of goods and services from
product market + transfer payments to the
household sector.
 Transfer payments - return for no service, for
example, welfare payments, unemployment
compensation, pension, etc.
 The government collects its money in the form of
tax, which makes up most of the government
revenue. But the government does not always
balance their budgets. The government always
tends to spend more than it takes in as taxes.
Four-Sector Economy
Four-Sector Economy
 In real life, only four-sector economy
exists. The four-sector economy is
composed of following sectors, i.e.:
(i) Household sector,
(ii) Business sector,
(iii) The government, and
(iv) Transaction with ‘rest of the world’ or
foreign sector or external sector.
Four-Sector Economy
 The foreign sector includes everyone and everything
(households, businesses, and governments) beyond the
boundaries of the domestic economy.
 It buys exports produced by the domestic economy and
produces imports purchased by the domestic economy,
which are commonly combined into net exports (exports
minus imports).
 With the inclusion of this sector, the economy becomes
an open economy.
 The transaction with ‘rest of the world’ involves import
and export of goods and services, and new foreign
investment. It is illustrated in the following figure.
Four-Sector Economy
 In four-sector economy, goods and services available for the
economy’s purchase include those that are produced domestically
(Y) and those that are imported (M).
 Thus, goods and services available for domestic purchase is Y+M.
Expenditure for the entire economy include domestic expenditure
(C+I+G) and foreign made goods (Export) = X. Thus:
Y+M=C+I+G+X
Y = C + I + G + (X – M)
Where, C = Consumption expenditure
I = Investment spending
G = Government spending
X = Total Exports
M = Total Imports
X – M = Net Exports

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The Circular

 the sole buyer of goods and services,

(ii) Business Sector:

 the sole producer and supplier of goods and services.

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