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Circular flow


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Circular flow

  1. 1. Circular flow of income or circular flow*Refers to a simple economic model which describes the reciprocal circulation ofincome between producers and consumers*In the circular flow model, the inter-dependent entities of producer and consumer arereferred to as "firms" and "households" respectively and provide each other with factorsin order to facilitate the flow of income.*Real Flow and Money Flow. Real Flow- In a simple economy, the flow of factorservices from households to firms and corresponding flow of goods and services fromfirms to households s known to be as real flow.FirmsProvide consumers with goods and services in exchange for consumer expenditure and"factors of production" from households.Human wants are unlimited and are of recurring nature therefore, production processremains a continuous and demanding process. In this process, household sectorprovides various factors of production such as land, labor, capital and enterprise toproducers who produce by goods and services by coordinating them. Producers orbusiness sector in return makes payments in the form of rent, wages, interest andprofits to the household sector.Household sector spends this income to fulfill its wants in the form of consumptionexpenditure.
  2. 2. Business sector supplies those goods and services produced and get income in returnof it.Thus expenditure of one sector becomes the income of the other and supply of goodsand services by one section of the community becomes demand for the other.A continuous flow of production, income and expenditure is known as circular flow ofincome. It is circular because it has neither any beginning nor an end. The circular flowof income involves two basic assumptions 1. In any exchange process, the seller or producer receives the same amount what buyer or consumer spends. 2. Goods and services flow in one direction and money payment to get these flow in return direction, causes a circular flow.Money Flow- In a modern two sector economy, money acts as a medium of exchangebetween goods and factor services.Money flow of income refers to a monetary payment from firms to households for theirfactor services and in return monetary payments from households to firms against theirgoods and services.Household sector gets monetary reward for their services in the form of rent, wages,interest, and profit form firm sector and spends it for obtaining various types of goods tosatisfy their wants. Money acts as a helping agent in such an exchange.Two Sector ModelIn the simple two sector circular flow of income model the state of equilibrium isdefined as a situation in which there is no tendency for the levels of income (Y),expenditure (E) and output (O) to change,Y=E=OThis 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 factorowners spend this income on goods which leads to a circular flow of income.Three Sector ModelIt includes household sector, producing sector and government sector.
  3. 3. It will study a circular flow income in these sectors excluding rest of the world i.e. closedeconomy income.Here flows from household sector and producing sector to government sector are in theform of taxes.The income received from the government sector flows to producing and householdsector in the form of payments for government purchases of goods and services as wellas payment of subsides and transfer payments.Every payment has a receipt in response of it by which aggregate expenditure of aneconomy becomes identical to aggregate income and makes this circular flow andunending.Four Sector ModelA modern monetary economy comprises a network of four sector economies this are-1.Household sector 2.Firms or producing sector 3.Government sector 4.Rest of theworld sector. Each of the above sectors receives some payments from the other in lieu of goods andservices which makes a regular flow of goods and physical services. Money facilitatessuch an exchange smoothly.A residual of each market comes in capital market as saving which inturn is invested infirms and government sector.Five sector modelLEAKAGES INJECTIONSaving (S) Investment (I)Taxes (T) Government Spending (G)Imports (M) Exports (X)The five sector model of the circular flow of income is a more realistic representation ofthe economy. The first is the Financial Sector that consists of banks and non-bank intermediaries whoengage in the borrowing (savings from households) and lending of money. In terms ofthe circular flow of income model the leakage that financial institutions provide in theeconomy is the option for households to save their money.
  4. 4. This is a leakage because the saved money cannot be spent in the economy and thusis an idle asset that means not all output will be purchased.The injection that the financial sector provides into the economy is investment (I) intothe business/firms sector.The leakage that the Government sector provides is through the collection of revenuethrough Taxes (T) that is provided by households and firms to the government. For thisreason they are a leakage because it is a leakage out of the current income thusreducing the expenditure on current goods and services.The injection provided by the government sector is Government spending (G) thatprovides collective services and welfare payments to the community. An example of atax collected by the government as a leakage is income tax and an injection into theeconomy can be when the government redistributes this income in the form of welfarepayments that is a form of government spending back into the economy.The final sector in the circular flow of income model is the overseas sector whichtransforms the model from a closed economy to an open economy. The main leakagefrom this sector are imports (M), which represent spending by residents into the rest ofthe world. The main injection provided by this sector is the exports of goods andservices which generate income for the exporters from overseas residents.In terms of the five sector circular flow of income model the state of equilibriumoccurs when the total leakages are equal to the total injections that occur in theeconomy. This can be shown as:Savings + Taxes + Imports = Investment + Government Spending + ExportsS + T + M = I + G + X.This can be further illustrated through the fictitious economy of Noka where:S + T + M = I + G + X$100 + $150 + $50 = $50 + $100 + $150$300 = $300Therefore since the leakages are equal to the injections the economy is in a stable stateof equilibrium. This state can be contrasted to the state of disequilibrium where unlikethat of equilibrium 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 usedto show the state of disequilibrium. Disequilibrium can be shown as:S+T+M≠I+G+X
  5. 5. Therefore it can be shown as one of the below equations where:Total leakages > Total injectionsP150 (S) + P250 (T) + P150 (M) >P75 (I) + P200 (G) + 150 (X)OrTotal Leakages < Total injectionsP50 (S) + P200 (T) + $125 (M) <P75 (I) + P200 (G) + P150 (X)The effects of disequilibrium vary according to which of the above equations theybelong to.If S + T + M > I + G + X the levels of income, output, expenditure and employment willfall causing a recession or contraction in the overall economic activity. But if S + T + M <I + G + X the levels of income, output, expenditure and employment will rise causing aboom or expansion in economic activity.To manage this problem, if disequilibrium were to occur in the five sector circular flow ofincome model, changes in expenditure and output will lead to equilibrium beingregained. An example of this is if:S + T + M > I + G + X the levels of income, expenditure and output will fall causing acontraction or recession in the overall economic activity. As the income falls (Figure 4)households will cut down on all leakages such as saving, they will also pay less intaxation and with a lower income they will spend less on imports. This will lead to a fallin the leakages until they equal the injections and a lower level of equilibrium will be theresult.The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model thelevels of income, expenditure and output will greatly rise causing a boom in economicactivity. As the households income increases there will be a higher opportunity to savetherefore saving in the financial sector will increase, taxation for the higher threshold willincrease and they will be able to spend more on imports. In this case when the leakagesincrease they will continue to rise until they are equal to the level injections. The endresult of this disequilibrium situation will be a higher level of equilibrium.Significance of Study of Circular Flow of Income1.Measurement of National Income- National income is an estimation of aggregation ofany of economic activity of the circular flow. It is either the income of all the factors ofproduction or the expenditure of various sectors of economy. However, aggregateamount of each of the activity is identical to each other.
  6. 6. 2.Knowledge of Interdependence- Circular flow of income signifies the interdependenceof each of activity upon one another. If there is no consumption, there will be nodemand and expenditure which infacts restricts the amount of production and income.3.Unending Nature of Economic Activities- It signifies that production, income andexpenditure are of unending nature, therefore, economic activities in an economy cannever come to a halt. National income is also bound to rise in future.4.Injections and Leakages Reference- A General Approach to Macroeconomic Policy.Difference between Real Flow and Money Flow1. Real flow is the exchange of goods and services between household and firmswhereas money flow is the monetary exchange between two sectors.2. In real flow household sector supplies raw material, land, labour, capital andenterprise to firms and in return firms sector provides finished goods and services tohousehold sector. Whereas in money flow, firm sector gives remuneration in the form ofmoney to household sector a wages and salaries, rent, interest etc.3. Difficulties of barter system for the exchange of goods and factor services betweenhouseholds and firms sector in real flow, whereas no such difficulty or inconveniencearise in money flow.4. When goods and services flow from one sector of the economy to another, it isknown as real flow.Phases or Stages of Circular Flow of IncomeProduction, consumption expenditure and generation of income are the three basiceconomic activities of an economy that go on endlessly and are titled as circular flow ofincome. Production gives rise to income, income gives rise to demand for goods andservices ; such a demand gives rise to expenditure and expenditure induces for furtherproduction. The whole process forms the basis for circular flow of income and relatedactivities- production, income and expenditure are known as phases or stages ofcircular flow of income.Production → Income → Expenditure → Production.1. Production Phase- Production means creation of utility to satisfy human wants. Itinvolves the co-ordination of all the factors of production in some desired ratio. This jobis performed by a producer or firm who takes an initiative with the motive of earningprofits. He hires land, labour, capital and an organization and makes them payment inthe form of rent, wages and salaries and interest. This phase is to produce goods andservices and after selling them, it generates income.
  7. 7. 2. Income Phase- Producing firms earn revenue from the sale of goods and servicesproduced by them. Whole of the earning is divided between factors provided byhousehold sector in the form of rent, wages, interest and profits. Such an income isclassified into three parts:- •Compensation of employees- Wages, salaries, commission,bonus etc. •Operating Surplus- Profits, rent, interest, royalty etc. •Mixed Income- Incomeof self- employed Thus production takes the shape of income of household sector.3. Expenditure Phase- Household sector spends its income to satisfy unlimited andrecurring human wants. Any saving out of total income takes the shape of investmenton capital goods that helps in generating the income of the economy. Expenditurebecomes the income of producing sector that promotes further the uninterrupted flow ofincome.Gross national incomeThe Gross national income (GNI) consists of: the personal consumption expenditure,the gross private investment, the government consumption expenditures, the netincome from assets abroad (net income receipts), and the gross exports of goods andservices, after deducting two components: the gross imports of goods and services, andthe indirect business taxes.The GNI is similar to the gross national product (GNP), except that in measuring theGNP one does not deduct the indirect business taxes.GNI versus GDPFor example, the profits of a Philippines-owned company operating in the UK will onlycount towards PHL GNI and UK GDP. If a country becomes heavily indebted, and payslarge amounts of interest to service this debt, this will be reflected in a decreased GNIbut not a decreased GDP. If a country sells off its resources to entities outside theircountry this will also be reflected over time in decreased GNI, but not decreased GDP.Therefore, the GDP appears more attractive for countries with increasing national debtand decreasing assets.GNP is a concept that goes hand in hand with GNI, GDP, and NNI. In contrast to theGNI, the GNP does not account for the balance of cross-country income, such asinterest and dividends. In contrast to the GDP, the GNP account for the values ofproducts and services based on citizenship of the owners rather than the territory of theactivityHow to Calculate the GNI GNI is an add up of Net Income from abroad and the GDP, one can calculate the GNIby the following formula.
  8. 8. Measures of national income and outputA variety of measures of national income and output are used in economics to estimatetotal economic activity in a country or region, including gross domestic product (GDP),gross national product (GNP), net national income (NNI), and adjusted national income(NNI* adjusted for natural resource depletion). All are especially concerned withcounting the total amount of goods and services produced within some "boundary”The boundary is usually defined by geography or citizenship, and may also restrict thegoods and services that are counted. For instance, some measures count only goodsand services that are exchanged for money, excluding bartered goods, while othermeasures may attempt to include bartered goods by imputing monetary values to them.National accountsArriving at a figure for the total production of goods and services in a large region like acountry entails a large amount of data-collection and calculation. Although someattempts were made to estimate national incomes as long ago as the 17th century,The systematic keeping of national accounts, of which these figures are a part, onlybegan in the 1930s, in the United States and some European countries. The impetus forthat major statistical effort was the Great Depression and the rise of Keynesianeconomics, which prescribed a greater role for the government in managing aneconomy, and made it necessary for governments to obtain accurate information so thattheir interventions into the economy could proceed as well-informed as possible.Market valueIn order to count a good or service, it is necessary to assign value to it.The value that the measures of national income and output assign to a good or serviceis its market value – the price it fetches when bought or sold.The actual usefulness of a product (its use-value) is not measured – assuming the use-value to be any different from its market value.Three strategies have been used to obtain the market values of all the goods andservices produced: the product (or output) method, the expenditure method, and theincome method.The product method looks at the economy on an industry-by-industry basis.The total output of the economy is the sum of the outputs of every industry. However,since an output of one industry may be used by another industry and become part of the
  9. 9. output of that second industry, to avoid counting the item twice we use not the valueoutput by each industry, but the value-added; that is, the difference between the valueof what it puts out and what it takes in.The total value produced by the economy is the sum of the values-added by everyindustry.The expenditure method is based on the idea that all products are bought by somebodyor some organisation.Therefore we sum up the total amount of money people and organisations spend inbuying things.This amount must equal the value of everything produced. Usually expenditures byprivate individuals, expenditures by businesses, and expenditures by government arecalculated separately and then summed to give the total expenditure. Also, a correctionterm must be introduced to account for imports and exports outside the boundary.The income method works by summing the incomes of all producers within theboundary. Since what they are paid is just the market value of their product, their totalincome must be the total value of the product. Wages, proprieters incomes, andcorporate profits are the major subdivisions of income.The output approachThe output approach focuses on finding the total output of a nation by directly findingthe total value of all goods and services a nation produces.Because of the complication of the multiple stages in the production of a good orservice, only the final value of a good or service is included in the total output. Thisavoids an issue often called double counting, wherein the total value of a good isincluded several times in national output, by counting it repeatedly in several stages ofproduction. In the example of meat production, the value of the good from the farm maybe P10, then P30 from the butchers, and then P60 from the supermarket. The value thatshould be included in final national output should be P60, not the sum of all thosenumbers, P100. The values added at each stage of production over the previous stageare respectively P10, P20, and P30. Their sum gives an alternative way of calculatingthe value of final output.Formulae:GDP(gross domestic product) at market price = value of output in an economy in theparticular year - intermediate consumption
  10. 10. NNP at factor cost = GDP at market price - depreciation + NFIA (net factor income fromabroad) - net indirect taxesThe income approachThe income approach equates the total output of a nation to the total factor incomereceived by residents or citizens of the nation. The main types of factor income are: Employee compensation (cost of fringe benefits, including unemployment, health, and retirement benefits); Interest received net of interest paid; Rental income (mainly for the use of real estate) net of expenses of landlords; Royalties paid for the use of intellectual property and extractable natural resources.All remaining value added generated by firms is called the residual or profit. If a firm hasstockholders, they own the residual, some of which they receive as dividends. Profitincludes the income of the entrepreneur - the businessman who combines factor inputsto produce a good or service.FormulaNDP at factor cost = Compensation of employees + Net interest + Rental & royaltyincome + Profit of incorporated and unincorporated NDP at factor cost.The expenditure approachThe expenditure approach is basically an output accounting method. It focuses onfinding the total output of a nation by finding the total amount of money spent. This isacceptable, because like income, the total value of all goods is equal to the total amountof money spent on goods. The basic formula for domestic output takes all the differentareas in which money is spent within the region, and then combines them to find thetotal output.Where:C = household consumption expenditures / personal consumption expendituresI = gross private domestic investmentG = government consumption and gross investment expendituresX = gross exports of goods and servicesM = gross imports of goods and servicesNote: (X - M) is often written as XN, which stands for "net exports"
  11. 11. GDP and Gross domestic product (GDP) is defined as "the value of all final goods andservices produced in a country in 1 year".Gross National Product (GNP) is defined as "the market value of all goods and servicesproduced in one year by labour and property supplied by the residents of a country."As an example, the table below shows some GDP and GNP, and NNI data for theUnited States: National income and output (Billions of dollars)Period Ending 2003Gross national product 11,063.3 Net U.S. income receipts from rest of the world 55.2 U.S. income receipts 329.1 U.S. income payments -273.9Gross domestic product 11,008.1 Private consumption of fixed capital 1,135.9 Government consumption of fixed capital 218.1 Statistical discrepancy 25.6National Income 9,679. NDP: Net domestic product is defined as "gross domestic product (GDP) minus depreciation of capital",[ similar to NNP. GDP per capita: Gross domestic product per capita is the mean value of the output produced per person, which is also the mean income.National income and welfareGDP per capita (per person) is often used as a measure of a persons welfare.Countries with higher GDP may be more likely to also score highly on other measuresof welfare, such as life expectancy. However, there are serious limitations to theusefulness of GDP as a measure of welfare: Measures of GDP typically exclude unpaid economic activity, most importantly domestic work such as childcare. This leads to distortions; for example, a paid nannys income contributes to GDP, but an unpaid parents time spent caring for children will not, even though they are both carrying out the same economic activity. GDP takes no account of the inputs used to produce the output. For example, if everyone worked for twice the number of hours, then GDP might roughly double, but this does not necessarily mean that workers are better off as they would have
  12. 12. less leisure time. Similarly, the impact of economic activity on the environment is not measured in calculating GDP. Comparison of GDP from one country to another may be distorted by movements in exchange rates. Measuring national income at purchasing power parity may overcome this problem at the risk of overvaluing basic goods and services, for example subsistence farming. GDP does not measure factors that affect quality of life, such as the quality of the environment (as distinct from the input value) and security from crime. This leads to distortions - for example, spending on cleaning up an oil spill is included in GDP, but the negative impact of the spill on well-being (e.g. loss of clean beaches) is not measured. GDP is the mean (average) wealth rather than median (middle-point) wealth. Countries with a skewed income distribution may have a relatively high per- capita GDP while the majority of its citizens have a relatively low level of income, due to concentration of wealth in the hands of a small fraction of the population.Because of this, other measures of welfare such as the Human Development Index(HDI), Index of Sustainable Economic Welfare (ISEW), Genuine Progress Indicator(GPI), gross national happiness (GNH), and sustainable national income (SNI) areused.Difficulties in Measurement of National IncomeThere are many difficulties when it comes to measuring national income, however thesecan be grouped into conceptual difficulties and practical difficulties.Conceptual Difficulties Inclusion of Services: There has been some debate about whether to include services in the counting of national income, and if it counts as output. Marxian economists are of the belief that services should be excluded from national income, most other economists though are in agreement that services should be included. Identifying Intermediate Goods: The basic concept of national income is to only include final goods, intermediate goods are never included, but in reality it is very hard to draw a clear cut line as to what intermediate goods are. Many goods can be justified as intermediate as well as final goods depending on their use. Identifying Factor Incomes: Separating factor incomes and non factor incomes is also a huge problem. Factor incomes are those paid in exchange for factor services like wages, rent, interest etc. Non factor are sale of shares selling old cars property etc., but these are made to look like factor incomes and hence are mistakenly included in national income. Services of Housewives and other similar services: National income includes those goods and services for which payment has been made, but there are scores of jobs, for which money as such is not paid, also there are jobs which people do themselves like maintain the gardens etc., so if they hired someone
  13. 13. else to do this for them, then national income would increase, the argument then is why are these acts not accounted for now, but the bigger issue would be how to keep a track of these activities and include them in national income.Practical Difficulties Unreported Illegal Income: Sometimes, people dont provide all the right information about their incomes to evade taxes so this obviously causes disparities in the counting of national income. Non Monetized Sector: In many developing nations, there is this issue that goods and services are traded through barter, i.e. without any money. Such goods and services should be included in accounting of national income, but the absence of data makes this inclusion difficult.