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Circular flow of income
- 2. The circularflow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services etc. between economic agents. It is a concept for better understanding of the economy as a whole .In its most basic form it considers a simple economy consisting solely of businesses and individuals, and can be represented in a so-called "circular flow diagram." In this simple economy, individuals provide the labor that enables businesses to produce goods and services. The circular flow diagrams illustrates the interdependence of the “flows,” or activities, that occur in the economy, such as the production of goods and services (or the “output” of the economy) and the income generated from that production. The circular flow also illustrates the equality between the income earned from production and the value of goods and services produced The circular flow analysis is the basis of national accounts and hence of macroeconomics.
- 3. Richard Cantillon 18thcentury French Economist Book: Essay on the Nature of Trade in General (1730) Five types of Economic Agents: Property owners ,Farmers, Entrepreneurs, Labors, Artisans François Quesnay 18th century French Economist Book: Tableau économique (Economic Table) (1758 ) Three economic agents: The "Proprietary" class consisted of only landowners. The "Productive" class consisted of all agricultural laborers. The "Sterile" class comprises of artisans and merchants. Karl Marx German Economist Book : Das Kapital John Maynard Keynes British Economist Book: General Theory of Employment , Interest and Money (1933) Frank Knight American Economist The first to visualize the modern circular flow of income model Book: The Economic Organization (1933)
- 5. The Producing SectorThe Household Sector The Government Sector The Financial Sector Rest of the world ( ROW) Sector
- 6. They are anindividual or groups that share their income. Require goods and services to satisfy their personal wants. Owns all resources ( i.e. labor, capital, land enterprise) The members of households have two functions. 1)They supply different factors of production. 2) Members of household also work as consumers
- 7. An organization thatproduces goods and services for sale. Main objective is to maximize profit in the production process. Uses resources provided by households to products goods and services. Sells those good and services for income The two main functions are as follows: 1) Produce goods and series and supply them in the market 2) Firms purchase inputs or raw materials from households to use them in the production process.
- 8. Just like householdsand 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, defense services, judiciary etc.
- 9. Consists of banksand 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.
- 10. It consists oftwo kinds of international economic transactions i.e. 1) Export and import of goods and services 2) Inflow and outflow of capital
- 11. TWO – SECTORMODEL THREE- SECTOR MODEL FOUR- SECTOR MODEL FIVE – SECTOR MODEL
- 12. In the basiccircular 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.
- 14. It includes householdsector, 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.
- 16. A modern monetaryeconomy comprises a network of four sector economy these are: •Household sector •Firms or Producing sector •Government sector •Financial sector. Each of the above sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. Money facilitates such an exchange smoothly. Financial institutions role it is to accept and protect the savings of consumers and to make investment funds available to producers.
- 18. In the fivesector model the economy is divided into five sectors: •Household sector •Firms or Producing sector •Financial sector •Government sector •Rest of the world sector: transforms the model from a closed economy to an open economy.
- 25. •In terms ofthe circular flow of income model the leakage that financial institutions provides is an option for households to save their money. •This is a leakage because the saved money can not be spent in the economy and thus it is an idle asset, that means no output will be purchased. •Further the injection that the financial sector provides into the economy is investment (I) into the business/firms sector. •Tax is paid to Government by households and firms . Therefore tax is a leakage because it is a leakage out of the current income and reduces the expenditure on current goods and services. • The injection provided by Government on this leakage is Government spending( services and welfare payments to the community) •Imports are leakage because it is the spending by residents into the rest of the world. • It becomes a leakage because the money in the home market goes to countries abroad. •The main injection provided by this sector is the exports of goods and services which generate income for the exporters from overseas residents.
- 26. In terms ofthe five sector circular flow of income model the state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy. This can be shown as: Savings + Taxes + Imports = Investment + Government Spending + Exports OR S + T + M = I + G + X.
- 27. Example: Savings = $100 Taxes=$150 Imports = $50 Investment =$50 Government Spending =$100 Exports = $150 Then: S + T + M = I + G + X $100 + $150 + $50 = $50 + $100 + $150 $300 = $300 Therefore, since the leakages are equal to the injections the economy is in a stable state of equilibrium.
- 28. STATE OF DISEQUILIBRIUM Here, the sum of total leakages does not equal the sum of total injections. By giving values to the leakages and injections the circular flow of income can be used to show the state of disequilibrium. Disequilibrium can be shown as: S + T + M ≠ I + G + X Therefore, it can be shown as one of the below equations where: • Total leakages > Total injections $150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + $150 (X) • Total Leakages < Total injections $50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + $150 (X)
- 29. Measurement of NationalIncome Knowledge of Interdependence - Circular flow of income signifies the interdependence of each of activity upon one another. If there is no consumption, there will be no demand and expenditure which in fact restricts the amount of production and income. Unending Nature of Economic Activities - It signifies that production, income and expenditure are of unending nature, therefore, economic activities in an economy can never come to a halt. National income is also bound to rise in future. Injections and Leakages