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Circular Flow

The circular flow of income model describes the continuous flow of money between producers and consumers in an economy. Producers use money from sales to pay households for resources, and households use income to purchase goods and services, completing the circular flow. The model can be expanded to include governments, which collect taxes and provide services, and financial institutions, which facilitate savings and investment. Equilibrium occurs when total injections, such as investment and exports, equal total leakages like savings and taxes.

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Abhinav Sachdeva
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51 views

Circular Flow

The circular flow of income model describes the continuous flow of money between producers and consumers in an economy. Producers use money from sales to pay households for resources, and households use income to purchase goods and services, completing the circular flow. The model can be expanded to include governments, which collect taxes and provide services, and financial institutions, which facilitate savings and investment. Equilibrium occurs when total injections, such as investment and exports, equal total leakages like savings and taxes.

Uploaded by

Abhinav Sachdeva
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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CIRCULAR FLOWOF

INCOME
Introduction
• The term circular flow of income or circular
flow of economic activity refers to a simple
economic model which describes the
circulation/flow of income between producers
and consumers.
• In the circular flow model, producer is referred
to as firmsand consumer are referred to as
households.
• The major exchanges are represented as
flows of money, goods and services, etc.
Determinant
s

Household Firm

Financial Foreign sector


Government
institutions
Househol
• It is a person ordgroup of people that share
their income.
• Require goods and services to satisfy
their personal wants.
• Owns all resources ( i.e. labor, capital,
land enterprise)
• The members of households have two
functions.
1. They supply different factors of production.
2. Members of household also work as
consumers.
Firm
• s
An organization that produces goods and services
for sale.
• Main objective is to maximize profit in the
production process
• Uses resources provided by households to
products goods and services
• Sells those good and services for income
• The two main functions are as follows:
1. Produce goods and series and supply them in the
market
2. Firms purchase inputs or raw materials from
households to use them in the production process.
Governmen
• t
Just like households and firms the
government also earns incomes and makes
expenses.
• Two major functions are:
1. Government earns revenue from either tax
or non tax sources both from households
and firms.
2. Government provides essential public services
such as maintenance of law and order,
defense services, judiciary etc.
Financial
• Consistsinstitutions
of banks and non-bank
intermediaries who engage in the
borrowing (savings from households) and
lending of money
• The leakage that financial institutions
provide in the economy is the option for
households to save their money.
Foreign
• It consists ofsector
two kinds of
international economic transactions
i.e.
1. Export and import of goods and
services
2. Inflow and outflow of capital.
Two Three
secto
rFour secto
Five
secto rsecto
r r
Two sector
• model
In the basic circular flow of income, or two sector circular
flow of income model, the state of equilibrium is defined
as a situation in which there is no tendency for the levels
of income (Y), expenditure (E) and output (O) to change,
that is:
• Y= E= O
• This means that the expenditure of buyers (households)
becomes income for sellers (firms). The firms then spend
this income on factors of production such as labour,
capital and raw materials, "transferring" their income to
the factor owners. The factor owners spend this income
on goods which leads to a circular flow of income.
Three sector
• It includesmodel
household sector, producing
sector and government sector.
• Here flows from household sector and
producing sector to government sector are in
the form of taxes.
• The income received from the government
sector flows to producing and household
sector in the form of payments for
government purchases of goods and services
as well as payment of subsidies and transfer
payments.
Four sector
• model
A modern monetary economy comprises a network of
four sector economy these are:
1. Household sector
2. Firms or Producing sector
3. Government sector
4. Financial sector.
• Each of the above sectors receives some payments
from the other in lieu of goods and services which
makes a regular flow of goods and physical services.
Money facilitates such an exchange smoothly.
• Financial institutions role it is to accept and protect
the savings of consumers and to make investment
funds available to producers.
Five sector
• In the fivemodel
sector model the economy
is divided into five sectors:
1. Household sector
2. Firms or Producing sector
3. Financial sector :
4. Government sector
5. Rest of the world sector: transforms the
model from a closed economy to an open
economy.
LEAKAGE AND
INJECTION
LEAKA INJECTIO
GE N
SAVINGS (S) INVESTMENTS
(I)

TAXES (T)
GOVERNMEN
T SPENDING
IMPORTS (G)

EXPORTS (E)
Injection

Leakage
• Leakage means withdrawal from the flow.
When households and firms save part of their
incomes it constitutes leakage. They may be in
form of savings, tax payments, and imports.
Leakages reduce the flow of income.
• Injection means introduction of income into
the flow. When households and firms borrow
the savings, they constitute injections.
Injections increase the flow of income.
Injections can take the forms of investment,
government spending and exports.
The state of
• equilibrium
In terms of the five sector circular flow of
income model the state of equilibrium
occurs when the total leakages are equal to
the total injections that occur in the
economy. This can be shown as:
• Savings + Taxes + Imports = Investment
+ Government Spending + Exports
• S+ T + M ≠ I + G + X
• If the state of the sum of total leakages does
not equal the sum of total injections it will
result in disequilibrium. Disequilibrium can
be shown as:
• Savings + Taxes + Imports ≠ Investment
+ Government Spending + Exports
• S+ T + M ≠ I + G + X
Significanc
•
e
Measurement of national income - National income is an
estimation of aggregation of any of economic activity of the
circular flow. It is either the income of all the factors of
production or the expenditure of various sectors of economy.
• Knowledge of interdependence - Circular flow of income signifies
the interdependence of each of activity upon one another. If there
is no consumption, there will be no demand and expenditure
which in fact restricts the amount of production and income.
• Unending nature of economic activities - It signifies that
production, income and expenditure are of unending nature,
therefore, economic activities in an economy can never come to a
halt. National income is also bound to rise in future.
• Injections and Leakages

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