Circular Flow of Income and Expenditure
It refers to the economy's ongoing, circular flow of cash and goods. It depicts how money and goods move back and forth between homes and commercial companies. A circular flow of income is a continuous stream of production, income, and expenditure. Due to the lack of a beginning or an end, it is circular.
Two fundamental assumptions are involved in the cyclic flow of income:
1. In every exchange, the producer or seller gets the same amount
spent by the buyer or consumer.
2. Money moves in one way while goods and services follow in the opposite direction.
A circular flow results from paying to have these flow in the other way.
Real flow, also known as product flow or output flow, is the movement of products and services between various economic sectors. Therefore, it includes:
Factor Flow
Product Flow
The exchange of goods and services for money is referred to as the money flow or nominal flow. Households offer the company key services in the form of land, labor, capital, and entrepreneurs and are compensated financially for doing so.
The funds are now used to purchase the company's goods and services
The flow of Income in Circular Phases
Production Phase: During this phase, businesses make items and services using inputs to produce these goods and services. It is referred to as a generation phase since it results in the generation of income.
Distribution Phase: During this stage, the company pays the families for the factor services they provided by paying them in the form of rent, wages, interest, and profit. Consequently, there is income distribution.
The phase of Disposition: Lastly, the factor income is used to finance the acquisition of goods and services for consumer use. As a result, the disposal of income occurs at this stage.
Two-Sector Model:
Let's assume two sector economy.
- A two-sector economy has two main sectors or groups: consumers (households), and producers, also known as enterprises.
- The firm receives factor services from households, and families supply factor services to the firm.
- The household's entire income is used for consumption.
- The enterprises sell all of the products and services they produce to homes.
- There is no third sector (domestic or international) in the economy.
- In this economy, there are two different kinds of markets: the product market and the factor market.
- There is no leakage, either in terms of taxes or savings.
- Firm factor payments are equal to family factor incomes.
- The amount that households spend on food, clothing, health, education, and other necessities is equal to the company's sales revenue. This implies that the enterprises receive a portion of the economy's overall income in the form of sales revenue.
- Money flow is equivalent to real flow.
The whole amount of goods and services produced by producers is equal to the total amount of goods and services consumed by consumers. It means that the money spent by purchasers (households) becomes the money earned by sellers (firms). The businesses then transfer their money to the owners of the factor by spending this income on factors of production including labor, capital, and raw materials. The factor owners spend this money on products, creating a cycle of income.
In reality, businesses and households frequently set aside a portion of their revenue, which causes leakage from the income cycle. Banks and other financial institutions are where the money is saved. Additionally, businesses borrow money from the financial system to make an investment, which causes money to enter the circular flow. As a result, financial institutions act as middlemen between investors and savers. Therefore, comprehending economic operations without reference to the financial system will be incomplete.
We know the output sold equals the value of production created (Y)
During a two-sector economy value of the output sold equals consumption expenditure plus investment expenditure, or Y=C+I.
National income is now equal to consumption plus saving, or Y=C+S.
By equating both, we have C+I=Y=C+S. The components of aggregate demand are displayed here by C+I=Y.
The allocation of national income to either consumption or saving is shown on the opposite side by the equation Y=C+S.
Thus in a two-sector economy where neither government nor foreign trade exists, investment is equal to saving.
Three Sector Model
Along with the government sector, it also comprises the home and production sectors. It will examine closed economy income, also known as circular flow income, in certain sectors but not elsewhere in the world. Taxes are the means through which money moves from the home and production sectors to the public sector in this instance. The Government revenue is transferred to the manufacturing and residential sectors in the mode of payment for goods and services purchased by the government in the form of money transfers and subsidies. Every payment is accompanied by a receipt, in which an economy's total spending equals its total income, which results in this perpetual motion and a circle.
The Three-Sector Economy's Assumptions
- Taxes are one of the ways that the government makes money. Tax payments are defined as the transfer of funds from individuals and commercial enterprises to the government.
- The government provides subsidies to the commercial sector while also making transfer payments to households. Transfer payments are viewed as taxable benefits.
- Government savings are transferred to the financial market where they are used to fund loans. The government spends on the economy and takes in a sizable portion of household income.
- Like individuals and businesses, the government makes purchases of goods and services.
- Government spending comes in many different forms, such as funding for capital goods, infrastructure, and products for the military and how factors such as wages, salaries, interest, rent, profit, etc. are paid.
- Taxes, asset sales, or borrowing are all possible ways for the government to pay for expenses.
Households, companies, and the government all contribute their surplus income to the capital markets as saves. The private or public sectors of the economy borrow these savings to invest in various projects.
The economy's total flow of expenditures is currently equal to Y= C + I + G.
Where Y stands for produced products and services, C for consumer spending, and G for government spending.
The total income is divided among taxes, savings, and consumption.
Therefore, Y= C + S + T is the result of adding taxation to the model to equalize government spending.
S is for saving, and T is for taxes.
Since the amount spent must equal the amount earned, the two equations are equated to give us C + I + G = C + S + T.
I + G = S + T is the result.
If the government's spending (G) exceeds its receipts (T), G >T, the government's budget will be in deficit. The government will borrow money from the financial sector to cover the deficit budget.
For this reason, private sector investment by business firms must be lower than family savings. As a result, government borrowing decreases private-sector investment, which is referred to as crowding out private investment.
Four Sector Model
A network of four sector economies makes up the modern monetary economy. These are the household sector, firms/industries that produce, government sector, and sector for the rest of the globe.
There is a consistent flow of physical products and services since one sector pays for the other in goods and services to some extent. Such a trade is easy with money. A portion of each market is carried over into the capital market as savings, which are then invested in businesses and the public sector. Technically, the cyclic flow will continue forever as long as lending equals borrowing, or as long as leakage equals injections. However, the financial sector of the economy performs this function.
Receipts from the household sector include income from rent, salaries, interest payments, and business sector profits, transfer payments made by the public sector.
The business sector, the government sector, and the capital markets all receive income from the household sector in the form of consumption, taxes, and savings, respectively.
Revenues from the business sector include those from the sale of products and services, money earned from exports, government subsidies, and capital market borrowings.
The major contributions from the business sector to the household sector, government sector, foreign sector, and capital market are made up of factor payments, import payments, and savings.
Taxes paid by individuals and businesses are included in government sector receipts, which also include interest and profits from investments, and remittances, whereas transfer payments, subsidies, grants, and other types are government sector payments. In addition to making transfer payments to the household sector such as pension funds, scholarships, etc., it pays the business sector in exchange for the commodities acquired. If tax revenues outpace expenditures, the surplus is invested in the stock market. When there is a cash shortage, the government borrows money from the capital market to keep the economy in balance.
In exchange for imported goods and services, the business sector pays the foreign sector. Payments were made to the business sector that imported the goods.
An economy's balance of payments is more than exports outpacing imports. If exports are more than imports, the economy will have a negative balance of payments. Depending on trade policy, the economy seeks to keep a balance between imports and exports.
Let's connect the outcomes of the three-sector model: I + G = S + T
To better understand the foreign sector, let's divide investment into domestic investment (D) and foreign investment (F).
D + F + G = S + T
When F = X-M
Where, X = Exports, M = Imports
D + (X - M) + G = S + T
D + X + G = S + T + M (Injection = Leakage)
This equation depicts the circular flow of income and spending in equilibrium. In other words, planned injection equals planned withdrawal.
The economy won't alter if all leakages and injections are equal. The economy will contract or enter a recession if leakages outpace injections, which will cause income levels to fall. The income level will increase and the economy will grow into recovery if injections are bigger than leakages.
Importance of Circular Flow
- It paints a precise picture of the market economy.
- It facilitates the national income calculation.
- It helps in establishing trade policies that encourage exports while reducing imports.
- It justifies the necessity of monetary policy by achieving a balance between savings and investment.
