INSTITUTE –University School of

Business
DEPARTMENT -Management
M.B.A
Managerial Economics(24-BAT605)
Faculty Name : Dr. Akriti Gupta(Assistant Professor)

Lecture 3.1.3 DISCOVER . LEARN . EMPOWER

Circular Flow of
Income
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 COURSE OBJECTIVES

• To integrate economic theory with business practice and highlight the application of
economic theory for business decision making.

• To learn how economics analysis can be used in formulating business policies and take
rational managerial decisions.

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 • Space for
visual (size
National Income 24)
and Its
Measurement
Course Outcome
CO Title Level Will be covered in this
Number lecture
CO4 Evaluate the methods of Evaluate
measurement of national income
and its impact on the economy.

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Macroeconomics

• Macroeconomics is a branch of economics field that studies how the aggregate economy
behaves.
• In macroeconomics, a variety of economy-wide phenomena is thoroughly examined such as,
inflation, price levels, rate of growth, national income, gross domestic product and changes in
unemployment
• Useful to estimate Nation
• N.I. Is the aggregate money value of goods and services produced in a country during a
particular year. It is the money value of all economic activities of a nation in a given year
• Economy is in equilibrium when income = output = expenditure
• Economic Activities in National Income
• Production, Exchange, Consumption, Distribution. Above Decisions are based on Economic
Agents: Households and Firm

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Circular Flow

• The circular flow of income and spending shows connections between different sectors of an
economy
• It shows flows of goods and services and factors of production between firms and households
• The circular flow shows how national income or Gross Domestic Product is calculated

Source : www.tutot2u.com
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Circular Flow of Income

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 Determinants
Households
• The primary economic function of households is to supply domestic firms with needed factors of
production – land, human capital, real capital and enterprise. The factors are supplied by factor
owners in return for a reward. Land is supplied by landowners, human capital by
labour, real capital by capital owners (capitalists) and enterprise is provided by entrepreneurs.
Entrepreneurs combine the other three factors, and bear the risks associated with production.
• Firms
• The function of firms is to supply private goods and services to domestic households and firms, and
to households and firms abroad. To do this they use factors and pay for their services.

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Source : www.tutot2u.com
Determinants

• Government • 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, defence services, judiciary etc.

• Financial institutions • Consists 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 sector • It consists of two kinds of international economic transactions i.e. 1. Export
and import of goods and services 2. Inflow and outflow of capital.

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Models

Source : www.tutot2u.com
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Two Sector Model

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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.
. So the circular flow of money will continue.

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 Three sector Model
• It includes 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.

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Source : www.tutot2u.com
Four sector Model

• Four sector is realistic and practical as it consists of four primary sectors. These sectors are
households, businesses, the government, and the foreign sector (or the rest of the world).
The foreign sector primarily means the export and import of goods and services.

• Therefore, this Four Sector Model is also called an Open Economy Model. In the Four Sector
Model, imports are treated as expenditure and become a leakage. Whereas exports boost the
national income.

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Assumptions of the Four Sector Model
This model drops the unrealistic assumptions of the two- and three-sector models.
Following are the assumptions of a four-sector model:

• The entry and recognition of the Foreign Sector in this model leads to no restrictions on
the import and export in general. Specific restrictions like the trading country, product, etc
may be there.

• The Government intervention is minimal.

• Both domestic and foreign markets feature perfect competition.

• Household exports labor and capital, while businesses export goods and services.

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Household Sector
The Household Segment plays a critical role in the Economic Development of any Country.
This sector acts as:
• A producer: Small businesses – self-employed and family businesses does make some
products and sell the same. And gets money from other sectors by selling these goods and
services.

• Works as a factor of production: They provide resources to the businesses as well as the
public in the form of labor, professionals-Doctors, Engineers, Lawyers, Consultants, etc. They
earn income in the form of rent on owned properties, fees, and remuneration for the work and
services provided to other sectors as well as to the household segment.

• Transfer payments: This segment also gets various transfer payments from the government in
the form of subsidies, welfare activities, and so on.

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• Acts as a consumer: households consume various goods and services produced and sold by
the businesses. The major outgo of the household segment is in the form of consumption only.
They also pay for the imports of goods and services.

• Pays taxes to the Government: Besides the businesses, the households form a large chunk,
rather than the biggest chunk of taxpayers to the government. They pay direct taxes in the
form of income tax, wealth tax, gift tax, etc. They also pay indirect taxes in the form of VAT,
Sales Tax, Service Tax, GST, etc.

• Act as Saver: Households are the biggest block of savers and investors in an economy. Every
other segment-businesses and the government try to woe their savings. The money left over
from their income, after fulfilling all their consumption needs, is saved. These savings get
deposited with banks and financial institutions. Part of it also goes for investment in the stock
market, real estate, bullion, and so on.

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Business Sector

• Businesses get revenue from selling goods and services to households, as well as through
exports. They also get subsidies from the government.

• On the other hand, payments from businesses to other sectors include factor payments, taxes,
import payments, and more.

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Government Sector

• The segment includes two types of activities. The First one is the governance, welfare
activities, services, and so on. The second segment is where the government owns and
operates certain businesses.

• The primary income source for the government is tax collections from households and
businesses. Also, the government gets interests and dividends from investing in businesses, as
well as international grants and loans.

• On the other hand, payment from the government includes transfer payments, subsidies,
grants, and more. The transfer payments involve sending money to households through
pension funds, scholarships, and more. Also, the government buys goods and services from
businesses.

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Foreign Sector

• This sector gets income from businesses, governments, and households who import goods and
services from other countries. On the other hand, the foreign sector makes payments to
businesses and governments when they export goods and services to other countries. It also
makes factors payment to households.

• In the case of exports being more than imports, there is a surplus balance of payment. And,
when the imports exceed exports, there is a deficit balance of payment in the economy. The
government uses different policies to maintain a balance between imports and exports.

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• foreign countries. The foreign firms interact with the domestic firms and households through export and
import of goods and services. Also, the foreign sector gets involved in borrowing and lending operations in a
country through financial market. The goods and services produced within the domestic territory which are
sold to the foreigners are called exports. The Figure 3 shows a typical 4-sector model of economy

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Five sector Model
• The five-sector model has all the sectors that are there in the four-sector model (Households,
businesses, government, and foreign sector). In addition to these four, the five-sector model has the
fifth sector, and it is the financial sector.

• A financial sector is very crucial for the smooth operation of an economy. This sector provides
borrowing and lending services to the other sectors in an economy. Extra income from other sectors
flows into the financial sector in the form of savings.

• And the financial sector uses these savings to give loans to other sectors. Moreover, the financial
sector allows households, businesses, and government to invest their savings to earn interest and
dividend income.

• Household Sector receives factor income (rent, wages, etc.) from the businesses and transfer
payments from the government. Expenditure from households in the form of consumption, taxes, and
import goes to businesses, the government, and the foreign sector. Any remaining income with the
households will go to the financial sector in the form of savings. 23
• Businesses get income from selling their goods and services to the household sector, foreign
sector, and government. Also, the business sector gets government subsidies. Expenditure
from businesses is in the form of wages and rent to households, import payments to the
foreign sector, and taxes to the government. The savings (or profit) from businesses go into
the financial sector.

• For the government, the main source of income are taxes from households, businesses, and
the financial sector. The government also gets interest and dividend income from investing its
savings into the financial sector. The expenditure from the government is in the form of
transfer payments, subsidies, grants, import payments, etc.

• The foreign sector gets money from businesses, the government, and households in the form
of import payments. Expenditure from the foreign sector is in the form of payment for
exports from businesses, government, and households.
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• Like with other models, there are injections (money coming into the economy) and leakages
(money going out of the economy) in the five-sector model as well.

• Injections in this model are in the form of Government Spending (G), Exports (X), and
Investment (I). And leakages are in the form of Imports (M), Savings (S), and Tax (T).

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 Summary

• The circular flow of income is illustrated in the circular flow model of the economy, which is
one of the most significant basic models within economics. This model shows how different
units in an economy interact, breaking things down in a highly simplified manner.
• It shows how household consumption is a firm’s income, which pays for labour and other
factors of production, and how those firms provide households with income.
• The circular flow of income demonstrates how economists calculate national income, or
gross domestic product (GDP).
• The two cycles described above are crucial parts of the basic functioning of a
capitalist economy. Central to the concept of the circular flow of income, and what it attempts
to represent in the most basic possible terms, is this key idea: that income flows in a cycle as
we both purchase goods/services and earn income via labour producing such goods/services.

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References
• T1: Pindyck, Robert and Rubinfeld, Daniel (2017), Microeconomics, 8 th Edition, Pearson
Publication
• T2: Varian, R and Hal, J (2014), Intermediate Microeconomics, 8th Edition, East-West
Press.
• T3: Dwivedi, D.N, (2015), Macroeconomics – Theory and Policy, 4th edition, Tata
McGraw Hill Publications.
• REFERENCE BOOKS
•
• R1: William J. Baumol, Alan S. Blinder, (2016), Micro Economics – Principles and policy,
13th edition, Cengage Learnings
• R2: Mankiw, Gregory N, (2014), Principles of Macroeconomics, 8th edition, Cengage
Learning.

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Web Link
• https://www.intelligenteconomist.com/circular-flow-model/

Video Link
https://www.youtube.com/watch?v=ZIPO7fraSyo

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 Blackboard
Assessment Pattern

Components HT-1 HT-2 Assignment Surprise Test Business Quiz GD Forum Attendance Scaled
Marks

Max. Marks 10 10 6 4 4 4 2 40

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THANK YOU