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Chapter 5. Circular flow NI

this chapter focuses on NI of an economy

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0% found this document useful (0 votes)
8 views19 pages

Chapter 5. Circular flow NI

this chapter focuses on NI of an economy

Uploaded by

kahzan300
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
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Circular flow of NI

Two, Three and Four Sectors Economy


Chapter outcome
• Know the four macroeconomic sectors and the three markets.
• Learn the interdependence among the sectors and the markets
• Identify the different models of the circular flow of income.
• Evaluate the leakages and injections in the circular flow.
• Analyses the significance of circular flow of income in macroeconomics.
The Concept of Circular flow
• The circular flow of income describes the movement of goods or services
and income among the different sectors of the economy. It illustrates the
interdependence of the sectors and the markets to facilitate both real and
monetary flow
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 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.
Four 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 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
• 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
The Circular Flow of Income in a Two-Sector Model

• 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.
• In this model, Y = C
• where, Y is Income and C is Consumption
FIGURE 1 THE CIRCULAR-FLOW DIAGRAM

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
•Firms sell
Goods Goods and
•Households buy
and services services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labor, land,


production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

8
Copyright © 2004 South-Western
Two-Sector Model
The Circular Flow of Income in a Three – Sector Model

• The three sector model of circular flow of income highlights the role
played by the government sector. This is a more realistic model which
includes the economic activities of the government however; we continue
to assume the economy to be a closed one. There are no transactions
with the rest of the world. The government levies taxes on the
households and the firms and it also gives subsidies to the firms and
transfer payments to the household sector
• In this model, the equilibrium condition is as follows:
• Y=C+I+G
• Where, Y = Income; C = Consumption; I = Investment and G = Government
Expenditure
Three – Sector Model
Three – Sector Model
The Circular Flow Of Income in a Four Sector
Model
• This is the complete model of the circular flow of income that
incorporates all the four macroeconomic sectors. Along with the above
three sectors it considers the effect of foreign trade on the circular flow.
With the inclusion of this sector the economy now becomes an ‘open
economy’. Foreign trade includes two transactions, i.e., exports and
imports
• In this model, the equilibrium condition is as follows:
• Y = C + I + G + NX
• NX = Net Exports = Exports (X) – Imports (M)
Four Sector Model
Four Sector Model
Leakages and Injections in the Circular Flow of
Income
The flow of income in the circular flow model does not always remain constant. The volume of
income flow decrease due to the leakages of income in the circular flow and similarly, it increases
with the injections of income into the circular flow.

Leakages: A leakage is referred to as an outflow of income from the circular flow model. Leakages
are that part of the income which the household withdraw from the circular flow and is not used to
purchase goods and services. This part of the income does not go to the goods market. There are three
main leakages and these are:
• Saving:
• Taxes
• Imports
• Thus, we see that leakages reduce the volume of income from the circular flow of income.
• Leakages = S + T + M
• Where, S = Saving; T = Taxes; and M = Imports
Injections: An injection is an inflow of income to the circular flow. The
volume of income increases due to an injection of income in the circular flow.
There are three main injections and these are:
• Investment:
• Government Expenditure:
• Exports:
• Injections = I + G + X
• Where, I = Investment; G = Government Expenditure; and X = Exports
Balance of leakages and Injections in an open economy is;
S + T + M = I + G + X Or, (S –I) = (G – T) + (X – M) The
Leakage and Injection
Thanks

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