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Circular Flow of Income

The document discusses the circular flow of income in a four sector economy consisting of households, firms, government, and the external sector. It explains the flows between these sectors, including factor payments from firms to households, consumption expenditure from households to firms, taxes from households and firms to government, and imports and exports between the domestic and external sectors. The circular flow shows that national income equals consumption + investment + government spending + net exports, and that total injections of investment, government spending, and net exports must equal total leakages of savings and taxes for the circular flow to remain in equilibrium.

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Dhawal Raj
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163 views12 pages

Circular Flow of Income

The document discusses the circular flow of income in a four sector economy consisting of households, firms, government, and the external sector. It explains the flows between these sectors, including factor payments from firms to households, consumption expenditure from households to firms, taxes from households and firms to government, and imports and exports between the domestic and external sectors. The circular flow shows that national income equals consumption + investment + government spending + net exports, and that total injections of investment, government spending, and net exports must equal total leakages of savings and taxes for the circular flow to remain in equilibrium.

Uploaded by

Dhawal Raj
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Circular Flow of Money

Learning objective

To discuss the various sectors in an economy.


To understand the inter-linkage between the various
sectors.
To evaluate the implications of the leakages and
injections in circular flow of income.
Circular Flow of Economic Activities and
Income
The simple model of the circular flow assumes two players

Firms

• Produce and supply the goods and services.

• Require various factors of production to produce these goods and services.

Households

• Include a set of individuals living in the same house

• Take joint decision about the consumption of goods and services.

• Provide services in terms of factor inputs to the firms

• Get paid for these services by firms which households spend on consumption.
• Money flows from firms to households as factor payments and from
households to firms as expenditure on goods and services.
• It is a circular flow of money or income
Circular Flow of Income
(Two Sector Economy)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)
Factor Inputs

Financial
Households Savings (S) Market Investment (I) Firms

Goods and
Services (O)

Consumption
expenditure
(C)

In the equilibrium Y=C+S=C+I=E=O


Let’s Poll

The GDP deflector reflects


(a)Only the quantity produced
(b)Both the quantity produced and the prices of
goods and services
(c)Only the Price of goods and services
(d)None of these
Circular Flow of Income
(Four Sector Economy)
The third sector is Government (G)
• Government Spending
– On provision of public utility goods and services.
– Provides salaries to the households
– Pays to firms for purchases of goods and services
• Government Revenue
– Households and firms pay various taxes and other payments and
provide factor inputs to the government.
– Government borrows from the financial market to fill revenue gap.
The fourth sector is the external sector
• Imports (M): Outflow of income occurs when the domestic firms buy
goods and services from foreign ones.
• Exports (X): Inflow of income takes place when foreign firms buy goods
and services from domestic ones
Circular Flow of Income
(Four Sector Economy)
Government
(G)
Taxes
Taxes Factor
Payments Remittances
for purchases
Salaries
Factor Inputs

Savings (S)

Households Financial Market Investment Firms


(I)

Imports Imports
Goods (M)
(M) (O)
Consumption
Expenditure

Foreign Nations Exports


Exports (X-M) (X)
(X)
National Income=C+I+G+(X-M)
Let’s Poll

Which of the following is a Real Flow in a circular


flow?
(a)Taxes
(b)Subsidies
(c)Goods and Services
(d)Grants
Circular Flow of Income
(Four Sector Economy)
• National income includes expenditures on consumption investment, government
and net of exports (X-M)

National Income=C+I+G+(X-M)

• Since national income can either be consumed, or saved, or paid as tax to the
government:

C+I+G+(X-M)=C+S+T

I+G+(X-M) =S+T

• Sum of private investment and expenditure on net exports is equal to the sum of
savings and tax revenue. Thus:

I+G+X =S+T+M

• Therefore, W=J

• At equilibrium, total injections are equal to total withdrawals.


Mention two important leakages in the circular
flow of national income.

Mention two important injections in the circular


flow of national income
Thank You

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