The Circular Flow
of Income: Meaning, Sectors, and Importance
Contents:
1. Meaning
2. Circular Flow in a
Two-Sector Economy
3. Circular Flow in a
Three-Sector Closed Economy
4. Importance of the
Circular Flow
1. Meaning:
The circular flow of income and
expenditure refers to the process whereby the national income and expenditure
of an economy flow in a circular manner continuously through time.
The various components of national
income and expenditure such as saving, investment, taxation, government
expenditure, exports, imports, etc. are shown on diagrams in the form of
currents and cross-currents in such a manner that national income equals
national expenditure.
2. Circular Flow in a Two-Sector Economy:
We begin with a simple hypothetical
economy where there are only two sectors, the household, and business. The
household sector owns all the factors of production, that is, land, labor, and
capital. This sector receives income by selling the services of these factors
to the business sector.
The business sector consists of
producers who produce products and sell them to the household sector or
consumers. Thus the household sector buys the output of products of the
business sector. The circular flow of income and expenditure in such an economy
is shown in Figure 1 where the product market is shown in the upper portion and
the factor market in the lower portion.
In the product market, the household
sector purchases goods and services from the business sector while in the
factor market the household sector receives income from the former for
providing services. Thus the household sector purchases all goods and services
provided by the business sector and makes payments to the latter in lieu of
these.
The business sector, in turn, makes
payments to the households for the services rendered by the latter to the
business-wage payments for labor services, profit for capital supplied, etc.
Thus payments go around in a circular manner from the business sector to the
household sector and from the household sector to the business sector, as shown
by arrows in the output portion of the figure.
There are also flows of goods and
services in the opposite direction to the money payments flows. Goods flow from
the business sector to the household sector in the product market, and services
flow from the household sector to the business sector in the factor market, as
shown in the inner portion of the figure. These two flows give GNP=GNI.
Circular Flow with Saving and Investment Added:
The actual economy is not as
explained above. In an economy, “inflows” and “leakages” occur in the
expenditure and income flows. Such leakages are saving, and inflows or
injections are an investment that equals each other.
Figure 2 shows how the circular flow
of income and expenditure is altered by the inclusion of saving and investment.
Expenditure has now two alternative
paths from household and product markets:
(i) Directly via consumption
expenditure, and
(ii) indirectly via investment
expenditure.
In Figure 2 there is a capital or
credit market in between saving and investment flows from households to
business firms. The capital market refers to a number of financial institutions
such as commercial banks, savings banks, loan institutions, the stock and bond
markets, etc. The capital market coordinates the saving and investment
activities of households and business firms. The households supply
saving to the capital market and the firms, in turn, obtain investment funds
from the capital market.
3. Circular Flow in a Three-Sector Closed Economy:
So far we have been working on the
circular flow of a two-sector model of an economy. To this we add the
government sector so as to make it a three-sector closed model of the 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 and government purchases are injections into 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, unemployment relief, sickness benefits, 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, take 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 in 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 services of the
household sector equal to the amount of taxes. Thus total sales again equal the production of firms. In this way, the circular flows of income and expenditure
remain in equilibrium.
Figure 3 shows that taxes flow out of
the household and business sectors and go to the government. Now the government
makes investments 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 then the government will incur a deficit equal to the difference 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 savings.
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.
Adding Foreign Sector: Circular Flow in a
Four-sector Open Economy:
So far the circular flow of income
and expenditure has been shown in the case of a closed economy. But the actual
economy is an open one where foreign trade plays an important role. Exports are injections or inflows into the economy.
They create income for domestic
firms. When foreigners buy goods and services produced by domestic firms, they
are experts 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. These exports and
imports in the circular flow are shown in Figure 4.
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 payments 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.
Like the business sector, modern
governments 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 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.
Figure 4 shows the circular flow of
the four-sector open economy with savings, 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, the exports of an economy must balance its imports. This is achieved by the foreign
trade policies adopted by the economy.
The whole analysis can be shown in
simple equations:
Y= C +I+ G … (1)
Where Y represents the production of goods
and services, C is for consumption expenditure, I investment level in the economy.
thank you
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