Meghna Gulhane

Tejas Patil
FUNCTIONING OF ECONOMY Jasvinder Kaur
Mansi Somani
(Circular Flow of Income and Consumption & Investment Function)
Ravi Bari
CONTENT
❖Introduction

❖Two Sector Model

❖Three Sector Model

❖Four Sector Model

❖Investment and Consumption Functions

THE EVOLUTION OF MONEY – FROM BARTER TO DIGITAL
FIRMS
• Producers: Firms produce goods and
services using factors of production from
households.
• Pay Factor Payments: Firms pay wages,
rent, interest, and profits to households.
• Sell Goods and Services: Firms sell goods
and services to households.
• Receive Consumption Expenditure: Firms
earn income from households' spending.
CIRCULAR FLOW
• Households earn income from factor payments
and spend it on consumption.
• Firms use this income to pay for factors of
production, continuing the cycle.
• This illustrates how expenditure in one sector
becomes income in another, creating a
continuous flow.
KEY CONCEPTS
• Two Sectors: Interaction between households and firms, excluding government,
finance, and foreign sectors.
• Real Flows: Goods and services flow from firms to households; factor services flow
from households to firms.
• Money Flows: Payments for goods/services flow from households to firms; factor
payments flow from firms to households.
HOW IT WORKS: HOUSEHOLDS
• Owners of Factors of Production: Provide labor,
land, and capital to firms.
• Consumers: Purchase goods and services
produced by firms.
• Spend all income: Assumed to spend all earnings
on consumption, with no saving or investment.
THE THREE-SECTOR MODEL
An economic framework that explains the flow of income and expenditure
between three sectors:

Households
Businesses
Government

It is a closed economy model (no foreign trade).

FLOW OF INCOME BETWEEN SECTORS

Households and Businesses:

Households provide labor, land, and capital to businesses.
Businesses pay wages, rent, and interest to households.
Households spend on goods and services produced by businesses.
Households and Government:
Households pay taxes to the government.
Government provides public services (education, healthcare) and transfer
payments (pensions, welfare).
Businesses and Government:
Businesses pay taxes to the government.
Government buys goods and services from businesses and provides subsidies.
IMPORTANCE OF THE THREE-
SECTOR MODEL
Understanding the Economy – Explains money,
goods, and services flow; impact of taxes and
spending.
Policy Making – Guides tax, spending, and
subsidy decisions; balances leakages & injections.
Economic Stability – Helps control inflation &
unemployment through government policies.
The Four-Sector Model
CIRCULAR FLOW OF INCOME: THE FOREIGN SECTOR

Foreign sector that deals with international trade and

financial transactions ,including export ,imports,
foreign investment ,and capital flows, influencing the
national income and overall economic activity in an
open economy.
 Imports, Exports, and FDI

Foreign Direct
Imports Exports
Imports represent money flowing out Exports represent money flowing into Investment (FDI)
of the domestic economy to purchase the domestic economy from foreign FDI involves investments from foreign
goods and services from abroad. buyers purchasing domestic goods and companies, impacting GDP,
services. employment rates, and technology
transfer within the host economy.
EXCHANGE RATES AND BALANCE OF
TRADE

Exchange Rate
Currency appreciation or depreciation significantly
impacts the cost
of imports and competitiveness of exports.
Balance of Trade (BOT)
The difference between a nation's exports and
imports; a surplus
boosts the economy, while a deficit may hinder it.
 Global Impact and Interdependence

1.GDP and Employment

Foreign trade significantly affects a country's GDP and
employment levels.

2.Globalization
Globalization and economic interdependence show how
nations rely on each other for trade and investments.

3.Trade Agreements
Trade agreements and international financial institutions
like the WTO and IMF play crucial roles in facilitating trade.
WHAT HAPPENS WHEN MONEY
STOPS FLOWING?
Households stop spending → Businesses earn less.
Businesses cut production → Workers lose jobs.
Unemployed workers spend less → Economy slows
down.
Government collects less tax → Less investment in
infrastructure, education, and healthcare.
INVESTMENT & CONSUMPTION FUNCTIONS

▪MPC
▪MPS
▪Relationship between MPS and MPC
▪Induced Investment
▪Autonomous Investment
▪Investment Function
▪Consumption Function
▪Problems
MPC (MARGINAL PROPENSITY TO
CONSUME)
MPC refers to the proportion of any additional income that a household or individual will
spend on consumption.
MPC = Change in Consumption / Change in Income
In simpler terms: If your income goes up by ₹100, and you decide to spend ₹80 of that, your
MPC would be 0.8 (or 80%). It shows how much of an increase in income people are likely to
spend.
For example:
If your income increases by ₹100 and you spend ₹70 of it your MPC is 0.7.
If your income increases by ₹100 and you spend ₹90, your MPC is 0.9.
The MPC is important because it shows how much of an economic stimulus will be spent
(rather than saved) when people receive more income.
MPS (MARGINAL PROPENSITY TO
SAVE)
MPS refers to the proportion of any additional income that a household or individual
will save instead of spending.
MPS = Change in Savings / Change in Income
In simpler terms: If your income goes up by ₹100, and you decide to save ₹20 of
that, your MPS would be 0.2 (or 20%). It shows how much of an increase in income
people are likely to save.
For example:
If your income increases by ₹100 and you save ₹30, your MPS is 0.3.
If your income increases by ₹100 and you save ₹50, your MPS is 0.5.
RELATIONSHIP BETWEEN MPC AND
MPS
MPC + MPS = 1
This means that every extra dollar earned is either spent (consumed) or saved. So, if
you spend 80% (MPC = 0.8) of your extra income, the remaining 20% (MPS = 0.2)
must be saved.
Example:
If you get an extra ₹100:
You spend ₹80 (MPC = 0.8).
You save ₹20 (MPS = 0.2).

MPC and MPS are key concepts in understanding how changes in income affect
overall consumption and savings in the economy.
INDUCED INVESTMENT
✓The investment which depends upon
the profit expectations and has a direct
influence of income level on it is known
as Induced Investment.
✓Induced Investment is income elastic.
✓It means that the induced investment
increases when income increases and
vice-versa.
✓In general, induced investment is done
by the private sector.
INVESTMENT WITHOUT INCOME?
How Can There Be Investment Without Income?
Even if there is no income in the economy, investment can still take place due
to the following reasons:
Government Spending – Governments invest in infrastructure, defense,
education, and healthcare irrespective of national income to boost economic
activity.
Foreign Investments – Foreign investors may invest in a country based on its
future potential, even if its current income is low.
Joke!
Technological Advancements – Firms invest in new technologies, expecting
future returns, even during economic downturns.
Borrowing & Credit Availability – Businesses and governments can take loans
or use their savings to invest even when income is low.
Entrepreneurial Expectations – Investors may foresee future profitability and
invest despite the current income levels.
AUTONOMOUS INVESTMENT
✓The investment on which the change in
income level does not have any effect
and is induced only by profit motive is
known as Autonomous Investment.
✓Autonomous Investment is income
inelastic.
✓It means that if there is a change in
income (increase/decrease), the
autonomous investment will remain
the same.
✓In general, autonomous investment is
done by the government sector.
INVESTMENT FUNCTION
The Investment Function shows the relationship between the level of investment
and various factors that influence it, such as the interest rate and expected future
profitability.
The simplest form of the investment function is: 𝐼 = 𝐼0 − 𝑏𝑖
Where:
 I is total investment.
 I₀ is autonomous investment (investment that occurs even without changes in the interest rate or
other economic factors).
 b is a positive constant indicating the sensitivity of investment to changes in the interest rate.
 i is the interest rate.
EXAMPLE
Suppose sensitivity of investment to the interest rate is 50, interest rate is 5% then
calculate total investment if Autonomous investment is ₹1000.

Here 𝐼0 = ₹1000, 𝑏 = 50 and 𝑖 = 5%

Hence 𝐼 = 1000 − 50 × 5
𝐼 = ₹750
CONSUMPTION FUNCTION
The Consumption Function describes the relationship between total consumption
and total income in an economy.
It represents how much households consume at different levels of income.
The function generally takes the form 𝐶 = 𝐶0 + 𝑐𝑌
Where:
 C is total consumption.
 C₀ is the autonomous consumption (consumption when income is zero, typically funded by savings
or borrowing).
 c is the marginal propensity to consume (MPC), which shows the fraction of additional income that
households will spend on consumption.
 Y is total income (or output).
EXAMPLE
Calculate Consumption C, if total disposable income is ₹20,000 MPS=0.4 and
autonomous consumption ₹3000.

Consumption function 𝐶 = 𝐶0 + 𝑐𝑌
Here 𝐶0 = ₹3000 , 𝑐 = 𝑀𝑃𝐶 = 0.6 , 𝑌 = ₹20,000
∴ 𝐶 = ₹15,000