CIRCULAR FLOW OF
INCOME
Circular Income Flow in a Two
Sector Economy
Real flows of resources, goods and services have been shown in Fig.
6.1. In the upper loop of this figure, the resources such as land,
capital and entrepreneurial ability flow from households to business
firms as indicated by the arrow mark.
In opposite direction to this, money flows from business firms to the
households as factor payments such as wages, rent, interest and
profits.
In the lower part of the figure, money flows from households to firms as
consumption expenditure made by the households on the goods and services
produced by the firms, while the flow of goods and services is in opposite direction
from business firms to households.
Thus we see that money flows from business firms to households as factor
payments and then it flows from households to firms. Thus there is, in fact, a
circular flow of money or income. This circular flow of money will continue
indefinitely week by week and year by year. This is how the economy functions. It
may, however, be pointed out that this flow of money income will not always
remain the same in volume.
In other words, the flow of money income will not always continue at a constant
level. In year of depression, the circular flow of money income will contract, i.e.,
will become lesser in volume, and in years of prosperity it will expand, i.e., will
become greater in volume.
This is so because the flow of money is a measure of national income and will,
therefore, change with changes in the national income. In year of depression, when
national income is low, the volume of the flow of money will be small and in years
of prosperity when the level of national income is quite high, the flow of money will
be large.
In order to make our analysis simple and to explain the central issues involved, we
take many assumptions. 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.
Circular Income Flow with
Saving and Investment
When households save, their expenditure on goods and services will
decline to that extent and as a result money flow to the business
firms will contract. With reduced money receipts, firms will hire fewer
workers (or lay off some workers) or reduce the factor payments they
make to the suppliers of factors such as workers.
This will lead to the fall in total incomes of the households. Thus,
savings reduce the flow of money expenditure to the business firms
and will cause a fall in economy’s total income. Economists therefore
call savings a leakage from the money expenditure flow.
In free market economies there exists a set of institutions such as
banks, insurance companies, financial houses, stock markets where
households deposit their savings. All these institutions together are
called financial institutions or financial market. We assume that all
the savings of households come in the financial market. We further
assume that there are no inter-households borrowings.
It is business firms who borrow from the financial market for
investment in capital goods such as machines, factories, tools and
instruments, trucks. Firms spend on investment in order to expand
their productive capacity in future.
Circular Income Flow in a Three Sector
Economy with Government
Government purchases goods and services just as households and
firms do. Government expenditure takes many forms including
spending on capital goods and infrastructure (highways, power,
communication), on defence goods, and on education and public
health and so on.
Government expenditure may be financed through taxes, out of
assets or by borrowing. The money flow from households and
business firms to the government is labelled as tax payments in Fig.
6.3 This money flow includes all the tax payments made by
households less transfer payments received from the Government.
Transfer payments are treated as negative tax payments.
Another method of financing Government expenditure is borrowing
from the financial market. This can be represented by the money flow
from the financial market to the Government and is labelled as
Government borrowing
The government borrowing through its effect on the rate of interest
affects the behaviour of firms and households. Business firms
consider the interest rate as cost of borrowing and the rise in the
interest rate as a result of borrowing by the Government lowers
private investment. However, households who view the rate of
interest as return on savings feel encouraged to save more.
Money Income Flows in the Four Sector
Open Economy: Adding Foreign Sector
Foreigners interact with the domestic firms and households through
exports and imports of goods and services as well as through
borrowing and lending operations through financial market. Goods
and services produced within the domestic territory which are sold to
the foreigners are called exports.
On the other hand, purchases of foreign-made goods and services by
domestic households are called imports.
additional money flows that occur in the open economy when exports
and imports also exist in the economy.
In our analysis, we assume it is only the business firms of the
domestic economy that interact with foreign countries and therefore
export and import goods and services.
A flow of money spending on imports have been shown to be
occurring from the domestic business firms to the foreign countries
(i.e., rest of the world). On the contrary, flow of money expenditure
on exports of a domestic economy has been shown to be taking place
from foreign countries to the business firms of the domestic economy.
If exports are equal to the imports, then there exists a balance of
trade. Generally, exports and imports are not equal to each other. If
value of exports exceeds the value of imports, trade surplus occurs.
On the other hand if value of imports exceeds value of exports of a
country, trade deficit occurs.
National Income = C + I + G + NX
where NX represents net exports, X-M.
Since national income can be either consumed, saved or paid as
taxes to the Government we have
C + I + G + NX = C + S + T
