Circular Flow of Income

and
Expenditure
 The Four Macroeconomic Sectors
• The Household Sector
• The Firms Sector
• The Government Sector
• The Foreign Sector
 The Four Macroeconomic Sectors…
The Household Sector
• This sector includes all the individuals in the economy. The primary
function of this sector is to provide the factors of production.
• The factors of production include land, labour, capital and enterprise.
• The household sectors are the consumers who consume the goods
and services produced by the firms and in return make payments for
the same.
 The Four Macroeconomic Sectors…
The Firms Sector
• This sector includes all the business entities, corporations and
partnerships.
• The primary function of this sector is to produce goods and
services for sale in the market and make factor payments to the
household sector.
 The Four Macroeconomic Sectors…
The Government Sector
• This sector includes the center, state, and local governments.
• The prime function of this sector is to regulate the functioning of
the economy.
• The government sector incurs both revenue as well as
expenditure.
• The government earns revenue from tax and non-tax sources and
incurs expenditure for provide essential public services to the
people.
 The Four Macroeconomic Sectors…
The Foreign Sector
• This sector includes transactions with the rest of the world.
• Foreign trade implies net exports (exports minus imports).
• Exports include goods and services produced domestically and
sold to the rest of the world and imports include goods and
services produced abroad and sold domestically.
 The Three Markets
• The Goods Market
• The Factor Market
• The Financial Market
 The Three Markets…
• The Goods Market: In this market the goods and services are
exchanged among the four macroeconomic sectors. The consumers
are the household, government and the foreign sector while the
producers are the firms.
• The Factor Market: The factors of production are traded through this
market. For the production of final goods and services, the firms obtain
the factor services and make payments in the form of rent, wages and
profits for the services to the household sector.
• The Financial Market: This market consists of financial institutions
such as banks and non-bank intermediaries who engage in borrowing
(savings from households) and lending of money.
 Meaning of Circular Flow of Income

• It refers to cycle of generation of

income in the production process,
its distribution among the factors
of production and finally, its
circulation from households to
firms in the form of consumption
expenditure on goods and
services produced by them.
 Phases of Circular Flow of Income
• There are 3 different phases
(Production/generation, Income/distribution
and disposition/expenditure) in circular flow of
income, as shown in the given diagram.
• Production Phase/ Generation Phase: In this
phase, firms produce goods and services with
the help of factor services.
• Income Phase/ Distribution Phase: This phase
involves the flow of factor income (rent, wages,
interest and profit) from firms to the
households.
• Disposition /expenditure Phase: In this phase,
the income received by factors of production, is
spent on the goods and services produced by
firms.
• In this way, income generated in production
units reaches back to production units and
makes the circular flow complete.
 Types of Circular Flow
• There are two types of circular flows:
➢Real flow
➢Money Flow
 Types of Circular Flow…
Real Flow:
• Real flow refers to the flow of factor services from
households to firms and the corresponding flow of
goods and services from firms to households.
• As seen in the diagram, households provide factor
services to the firms which, in turn, provide goods
and services to them as a reward for their productive
services.
• It is also known as ‘Physical flow’.
• There is only exchange of goods and services
between the two sectors without involvement of any
money.
 Types of Circular Flow…
Money Flow
• Money Flow refers to flow of factor payments
from firms to households for their factor
services and corresponding flow of
consumption expenditure from households to
firms for purchase of goods and services
produced by the firms.
• As seen in the diagram, firms make factor
payments to households for their factor
services and households spend this income
on purchase of goods and services produced
by the firms.
• It is also known as 'Nominal flow’.
• It involves exchange of money between the two
sectors.
Difference between Real Flow and Money Flow
The Circular Flow of Income in a Two-Sectoral
Economies
(Without savings & Investment)
Assumption for Simple Two-Sector Economy
• In the first place, we assume that neither the households save from their incomes, nor the
firms save from their profits. We further assume that the government does not play any part
in the national economy.
• In other words, the government does not receive any money from the people by way of taxes,
nor does the government spend any money on the goods and services produced by the firms
or on the resources and services supplied by the households.
• Thirdly, we assume that the economy neither imports goods and services nor exports
anything.
• In other words, in our analysis, we have not considered the role of foreign trade.
• In this model, the economy is assumed
to be a closed economy and consists
of only two sectors, i.e., the household
and the firms. A closed economy is an
economy that does not participate in
international trade.
• In this model, the household sector is
the only buyer of the goods and
services produced by the firms and it is
also the only supplier of the factors of
production.
• The household sector spends the
entire income on the purchase of
goods and services produced by the
firms implying that there is no saving or
investment in the economy.
• The firms are the only producer of the
good and services.
• The firms generate income by selling
the goods and services to the
household sector and the household
sector earns income by selling the
factors of production to the firms.
The Circular Flow of Income in a Two-Sectoral
Economies
(With savings & Investment)
• In the previous model, we assumed that
the household sector spends its entire
income and that there is no saving in the
economy.
• However, in practice, the household
sector does not spend all its income; it
saves a part of it.
• The saving by the household sector would
imply monetary withdrawal (equal to
saving) from the circular flow of income.
• This would affect the sale of the firms
since the entire income of the household
would not reach the firm implying that the
production of goods and services would
be more than the sale.
• Consequently, the firms would
decrease their production which would
lead to a fall in the income of the
household and so on.
• There is one way of equating the sales
of the firms with the income generated;
if the saving of the household is
credited to the firms for investment
through the financial market, then the
income gap could be filled.
• If the total investment (I) of the firms is
equal to the total saving (S) of the
household sector then the equilibrium
level of the economy would be
maintained at the original level.
Circular Flow in a Three-sector
Economy
Circular Flow in a Three-sector
Economy
• The government also plays a crucial role
in the economic development of a
country.
• Therefore, the circular flow of income in a
three-sector economy includes
households, firms, and the government
sector.
• The government of a country acts as both
a firm and a consumer. As a firm or
producer, the government produces
goods and services for the economy.
• However, as a consumer, it spends
money on the consumption of goods and
services produced by the firms.
Circular Flow in a Three-sector
Economy
Besides the flows of circular income in the two-
sector economy with a financial market, the
additional flows due to the inclusion of the
Government are:
• Between Households and Government: The
money from the government to households
flows in an economy in two forms.
• First, in the form of transfer payments, such
as old age pensions, scholarships, etc.
• Second, in the form of factor payments for
hiring factor services of the households.
• This money flows back from households to
the government in the form of direct taxes,
such as interest tax, income tax, etc.
Circular Flow in a Three-sector
Economy
Between Firms and Government:
• The money from firms to the
government flows in an economy in
the form of direct and indirect taxes.
• However, the money from the
government to the firms flows into an
economy in the form of subsidies.
• In this case, the government grants
subsidies to the firms and makes
payments to the firms for the
purchase of goods and services
produced by them.
Circular Flow in a Three-sector
Economy
• The financial market also
plays an important role in a
three-sector economy, as the
government saves a part of
their earned income and
deposits the same in the
financial market.
• Besides, the government also
borrows money from the
financial market so it can
meet its expenditures.
Circular Flow in a Three-sector Economy
Role of Government Sector in an Economy

The Government Sector of an economy

performs the following activities:

• It collects taxes from the households and

firms.

• It makes the payment for the purchase of

goods and services from the firms.

• It also makes transfer payments to the

households and provides the firms with
subsidies.

• Lastly, Government saves and borrows

money by taking help from the financial
market.
Circular Flow in a Four-sector Economy
Circular Flow in a Four-sector Economy
• Besides households, firms, and the government, the foreign
sector also plays a crucial role in an economy.

• Therefore, the circular flow in a four-sector economy consists

of households, firms, government, and the foreign sector.

• Money flows in each of these sectors are as follows:

Circular Flow in a Four-sector Economy
• 1. Household Sector: The household
sector of an economy provides factor
services to the firms, government,
and the foreign sector for which it
received factor payments in return.
• Besides factor payments, the
households also receive transfer
payments like old age pensions,
scholarships, etc., from the
government and foreign sector.
• The household sector spends its
earned income on Payments for
goods and services purchased from
firms, payments for imports, and tax
payments to the government.
Circular Flow in a Four-sector Economy
2. Firms:
• The firms receive revenue for the
sale of goods and services from
the government, households, and
foreign sectors.
• They also receive subsidies from
the government to produce goods
and services.
• Besides, the firms make payments
for taxes to the government, factor
services to the households, and
imports to the foreign sector.
Circular Flow in a Four-sector Economy
3. Government:
• The government receives
revenue for the sale of goods
and services, fees, taxes, etc.,
from the firms, households,
and the foreign sector.
• It also makes factor
payments to households and
spends its revenue on
transfer payments and
subsidies.
Circular Flow in a Four-sector Economy
4. Foreign Sector:
• The foreign sector receives
revenue for the export of
goods and services from
firms, households, and the
government.
• It also makes payments to
firms and the government for
the import of goods and
services, and households for
the factor services.
Circular Flow in a Four-sector Economy
• The financial market also plays an important role in a four-
sector economy as the savings made by the households, firms,
and the government gets accumulated here and this money is
invested by the financial market in the form of loans to firms,
households, and the government.

• The inflows of money in the financial market in a four-sector

economy are equal to the outflows of money, which makes the
circular flow of income continuous and complete.