Circular flow of income?????• The term circular flow of income or circular flow of economic activity refers to “a simple economic model which describes the circulation/flow of income between producers and consumers”.• In the circular flow model, producer and consumer are referred to as "firms" and "households" respectively.
Significance of Study of Circular Flow of Income Measurement of National Income- National income is an estimation ofaggregation of any of economic activity of the circular flow. It is either the income of all the factors of production or the expenditureof various sectors of economy. Knowledge of Interdependence- Circular flow of incomesignifies the interdependence of each of activity upon one another Unending Nature of Economic Activities- It signifies that production,income and expenditure are of unending nature, therefore, economicactivities in an economy can never come to a halt. National income is also bound to rise in future. To understand about the leakages in economy and injections
Foreign Household sector Determinants Firms/ business Financial institutions
Households: It is a person or a group of people that share theirincome. The members of households have twofunctions:they supply different factors of productionmembers of household also work as consumers
Firms:An organization that produces goods andservices for sale.main objective is to maximize profit in theproduction process.The two main functions are as follows:Produce goods and services and supply themin the market.Firms purchase inputs or raw materials fromhouseholds to use them in the productionprocess
GovernmentJust like households and firms the government alsoearns incomes and makes expenses. Two majorfunctions played are:Government earns revenue either from tax or non-taxsources both from households and firms. Government provides essential public services such as maintenance of law and order, defence services, judiciary etc.
Financial institutionsFinancial Institution :consists of banks and non-bank intermediarieswho engage in the borrowing (savingsfrom households)and lending of money.the leakage that financial institutions provide in theeconomy is the option for households to savetheir money.
Foreign Market:It consists of two kinds of international economictransactions i.e.export and import of goods and servicesinflow and outflow of capital.
Have a glance on Two sector model Three sector model Four sector model Five sector model
TWO SECTOR MODEL
Three sector modelThree sector model is created by adding the Government sectorto the Two sector modelThree kinds of monetary flows between the government and therest of the economy i.e.1)direct taxes on both households andfirms2)government expenditure3)transfer payments andsubsidiesGovernment spends a part of its tax revenue as factor paymentsto the households and a part in the form of transfer payments aspension and food subsidy etc.
This circular flow of model showsthe four macro economic sectors of theeconomy i.e. household, business firm,government, and financial institutions.These four sectors capturefour fundamental macroeconomicfunctions and their expenditures arecombined together to purchase theeconomys total production.
To introduce the financial market, it is assumedthat household saves in the financial market.There are no inter-households borrowingIf the households save a part of their income in thefinancial market (such as banks, insurancecompanies, stock market etc), this reduces theexpenditure of household on goods and servicesUltimately it reduces the flow of money/income of theeconomy.So saving known as the leakage of the economy
Foreign Market(export and import):Goods and services produced within the domestic territorywhich are sold to the foreigners are called exports.Purchases of foreign made goods and services by domestichouseholds are called as imports.Here we assume that only business forms can interact withthe foreign countries and dealt with the export and import ofthe country.Money goes through import from the economy again returnback to the country through export activities.
Why savings become a leakage?????? In terms of the circular flow of income model theleakage that financial institutions provides an option forhouseholds to save their money.This is a leakage because the saved money can not bespent in the economy and thus it is an idle asset, thatmeans no output will be purchased.The injection that the financial sector provides into theeconomy is investment (I) into the business/firms sector.
How tax becomes a leakage?????Tax is paid to Government by households and firmsTax is a leakage because it is a leakage out of thecurrent income and reduces the expenditure on currentgoods and servicesThe injection provided by Government on this leakageis Government spending( services and welfarepayments to the community)For e.g.. Income tax collected by Govt is a leakage andGovt spends some amount as food subsidy as aninjection.
How Imports becomes a leakage?????Imports are leakage because it is the spendingby residents into the rest of the world.It becomes a leakage because the money in thehome market goes to countries abroad.The main injection provided by this sector isthe exports of goods and services whichgenerate income for the exporters from overseasresidents.
In five sector circular flow of income model, the state ofequilibrium occurs when the total leakages are equal tothe total injections that occur in the economy.This can be shown as:Savings + Taxes + Imports = Investment + GovernmentSpending + Exports S + T + M = I + G + X.