Circular flow of income

In every economy, three activities never stop: (i) production of goods and services, (ii) generation of
income and (iii) expenditure. They are the lifeline of an economy and they flow like a circle without a
beginning or an end. In the process, the producers produce goods and services, consumers buy these goods
and services and thereby generate income. The income so generated causes expenditure. Income flows in a
circular manner and hence, it is called a circular flow of income as it is a continuous process. There is no
end to this flow because there is no end to human wants.
Thus, circular flow of income refers to an unending flow of activities of production, income
generation and expenditure involving different sectors of the economy, particularly the producers (firms)
and households.
 Three phases of circular flow of income are:
1. Production of goods and services.
2. Generation or distribution of income.
3. Expenditure or disposition of income.

Circular flow of income in two sector economy

In a simple two-sector economy, there exists only two sectors i.e. household sector and business
sector or firm. The household spend their entire income, do that there is no savings. The economy is closed,
so that there are no exports and imports and there is no government intervention.
i. Household sector: They are the owners of the factor of production (that is Land, Labour, Capital and
Entrepreneur) and they are the consumer of goods and services hence they are the consuming unit.
ii. Business sector or firm: They are the users of the factors of production and the producer of goods
and services hence they are the producing unit.
The business sector hires factor services from the household sector. For providing their factor services to
the producers, the households get factor payments (factor incomes). Income is spent on purchase of final
goods and services. Expenditure generates demand for goods and services; this causes production of goods
and services and consequently, generation of income. Thus, the three flows of production, income and
expenditure move in circle. That is why it is called circular flow. This is illustrated in the diagram below:

St. Mary’s Higher Secondary School, Shillong

 Each sector depends on the other sector in one way or the other and this is called intersectoral
interdependence which can either be in the form of goods and services (real flow) or in the form of money
(money flow).
1. Real flow: It is the flow of factors of production from household to business sector and the flow of
goods and services from business to household sector.
2. Money flow: It is the flow of income for the payment of factors of production from business to
household sector and the flow of income for the payment of goods and services from the household
to the business sector.
Money flows are just the monetary expression of real flows. That is production is converted into income
and income is converted into expenditure. It is this conversion process which keeps the circular flow in a
state of circularity.
Thus, Production  Income  Expenditure

Concepts of leakages and injections:

In the real world, households save some part of their factor incomes for future contingencies, and
firms too, save some parts of their profits for financing new investment. Firms and households also borrow
money from the financial institutions for the same reasons
Savings and borrowings by households and business firms have two impacts on the circular flow of
income:
1. Leakages: They are withdrawals from the circular flow of income which means they reduce the flow
of income and hence reduce the demand for goods and services. Example, saving, taxation, imports.
2. Injections: They are additions to the circular flow of income which means the increases income or
they add to the production capacity of the economy and hence generate demand for goods and
services. Example, investment, exports, consumption expenditures.

Importance of circular flow of income:

1. It helps us to understand the inter-dependence among different sectors of the economy.
2. It helps in the estimation of national income.

Methods of calculating National Income

The circular flow model helps us to view national income from three different angles corresponding
to which the economists have suggested three methods of measuring national income. The three methods
are:
1. Value added/ Output/ Product Method
2. Income Method/ Distribution Method
3. Expenditure Method/ Disposition Method

All three methods give the same estimate of national income. Each method is important in its own way
as it refers to different approaches to study National Income. Following is a brief description of these
methods.

I. Value added or Output or Product Method: This method measures national income as the sum
total of final goods produced by all production units within the domestic territory of the country,
during the period of an accounting year. In this method, national income is measured at the
production stage.

Steps for estimating national income:

i. Identification of production units: Production units in an economy are classified into
primary, secondary and tertiary sectors.
a) Primary Sector: It includes all the production units which produce commodities by
exploiting natural resources. Example: agriculture, forestry, fishing, mining and
quarrying etc.

St. Mary’s Higher Secondary School, Shillong

 b) Secondary Sector: This sector transforms one type of commodity into another type
of commodity such as cloth produced from cotton, manufacturing, electricity, gas and
water supply.
c) Tertiary Sector: This sector renders services as compared to primary and secondary
sectors. This sector includes trade, transport and communication, banking, insurance,
government and professional services.
ii. Gross Value of Output (GVOMP) is calculated for each sector separately and then added to
find GDPMP.
GVOMP = Sales + Change in stocks
(Domestic sales + exports) + (closing stock – opening stocks)
iii. By deducting intermediate consumption from Gross Value Of Output At Market Price
(GVOMP) we get Gross Domestic Product At Market Price (GDPMP) or (GVAMP)
GDPMP = GVOMP – Intermediate Consumption
iv. Having estimated GDPMP, we now find out national income or NNPFC as follows:
NNPFC = GDPMP – Depreciation – NIT + NFIA

II. Income Method or Distribution Method: According to this method, national income is estimated
in terms of factor payments in the form of compensation of employees, rent, interest and profit to the
owners of factors of production (land, labour, capital and entrepreneurs) during an accounting year,
Here, national income is estimated at a stage where factor incomes are paid out by the producing
sector to the household sector for the factors of production.
Factor incomes are broadly classified as:
a) Compensation of Employees (C.O.E): Compensation of Employees is a reward for
rendering productive services by the workers which includes wages in cash, payments
in kind, social security contributions and pension on retirement.
b) Operating Surplus (OS): Operating surplus is income from property (such as rent,
royalty and interest) and income from entrepreneurship (Profit = dividends +
corporation tax + corporate savings).
c) Mixed Income (MI): Mixed income refers to the income of the self-employed
persons using their own labour, land, capital and entrepreneurship in their own
household enterprises. Their incomes are a mixture of wages, rent, interest and profit.
That is why it is called mixed income.

Steps for estimating national income:

i. Calculation of Domestic factor income (NDPFC)
NDPFC = C.O.E. + O.S + M.I
ii. Calculation of National Income (NNPFC)
NNPFC = NDPFC + NFIA

III. Expenditure Method or Disposition Method: According to this method, national income is
estimated in terms of expenditure on the purchase of final goods and services produced within the
economy during an accounting year. These expenditures are broadly classified into four categories:
a) Private final consumption expenditure (PFCE): It refers to expenditure on final
goods and services by the individuals, households and non-profit private institution
serving society.
b) Government final consumption expenditure (GFCE): It refers to expenditure on
final goods and services by the government, like expenditure on the purchase of goods
to satisfy collective wants, for e.g. expenditure on health, education, law and order,
etc.
c) Gross domestic capital formation (GDCF): It refers to purchase of final goods by
the producers. It includes Gross Domestic Fixed Capital Formation (GDFCF) and
change in stocks by producers in the country. GDFCF is expenditure on fixed assets
like machinery, equipment, factory building etc.

St. Mary’s Higher Secondary School, Shillong

 d) Net Exports(X – M): It refers to the difference between exports and imports during
an accounting year.

Steps for estimating national income:

i. Calculating the sum total of expenditure on domestically produced goods which is also called
GDPMP.
GDPMP = PFCE + GFCE + GDCF + (X – M)
ii. GDPMP is converted to NNPFC (national income) as follows:
NNPFC = GDPMP – Depreciation – NIT + NFIA

Precautions:
1. Value of intermediate goods and services is not included to avoid double accounting.
2. The sale and purchase of second-hand goods is not included in the estimation of national income
because these goods have already been accounted for during the year they were produced.
3. Imputed rent of owner occupied house and output for self-consumption is included to ensure a
complete representation of economic activity.
4. Transfer incomes like old age pensions, unemployment allowances, scholarships, pocket money etc.
and income from illegal activities like theft and gambling etc. are not included in national income as
these are not related to any value addition in the economy.
5. Only final expenditure on goods and services is to be included in national income to avoid error of
double counting.
6. Incomes from windfall gains like from lotteries should not be included in national income.

St. Mary’s Higher Secondary School, Shillong