Circular flow

Circular flow of income or circular flow

*Refers to a simple economic model which describes the reciprocal circulation of
income between producers and consumers

*In the circular flow model, the inter-dependent entities of producer and consumer are
referred to as "firms" and "households" respectively and provide each other with factors
in order to facilitate the flow of income.

*Real Flow and Money Flow. Real Flow- In a simple economy, the flow of factor
services from households to firms and corresponding flow of goods and services from
firms to households s known to be as real flow.

Firms

Provide 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 process
remains a continuous and demanding process. In this process, household sector
provides various factors of production such as land, labor, capital and enterprise to
producers who produce by goods and services by coordinating them. Producers or
business sector in return makes payments in the form of rent, wages, interest and
profits to the household sector.

Household sector spends this income to fulfill its wants in the form of consumption
expenditure.

Business sector supplies those goods and services produced and get income in return
of it.

Thus expenditure of one sector becomes the income of the other and supply of goods
and 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 of
income. It is circular because it has neither any beginning nor an end. The circular flow
of 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 exchange
between goods and factor services.

Money flow of income refers to a monetary payment from firms to households for their
factor services and in return monetary payments from households to firms against their
goods 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 to
satisfy their wants. Money acts as a helping agent in such an exchange.

Two Sector Model

In the simple 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,

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.

Three Sector Model

It includes household sector, producing sector and government sector.

It will study a circular flow income in these sectors excluding rest of the world i.e. closed
economy income.

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 subsides and transfer payments.

Every payment has a receipt in response of it by which aggregate expenditure of an
economy becomes identical to aggregate income and makes this circular flow and
unending.

Four Sector Model

A 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 the
world 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.

A residual of each market comes in capital market as saving which inturn is invested in
firms and government sector.

Five sector model

LEAKAGES INJECTION

Saving (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 of
the economy.

The first is the Financial Sector that consists of banks and non-bank intermediaries who
engage in the borrowing (savings from households) and lending of money. In terms of
the circular flow of income model the leakage that financial institutions provide in the
economy is the option for households to save their money.

This is a leakage because the saved money cannot be spent in the economy and thus
is an idle asset that means not all output will be purchased.

The injection that the financial sector provides into the economy is investment (I) into
the business/firms sector.

The leakage that the Government sector provides is through the collection of revenue
through Taxes (T) that is provided by households and firms to the government. For this
reason they are a leakage because it is a leakage out of the current income thus
reducing the expenditure on current goods and services.

The injection provided by the government sector is Government spending (G) that
provides collective services and welfare payments to the community. An example of a
tax collected by the government as a leakage is income tax and an injection into the
economy can be when the government redistributes this income in the form of welfare
payments 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 which
transforms the model from a closed economy to an open economy. The main leakage
from this sector are imports (M), which represent spending by residents into the rest of
the world. The main injection provided by this sector is the exports of goods and
services which generate income for the exporters from overseas residents.

In terms of the 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

S + 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 = $300

Therefore since the leakages are equal to the injections the economy is in a stable state
of equilibrium. This state can be contrasted to the state of disequilibrium where unlike
that 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 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

P150 (S) + P250 (T) + P150 (M) >P75 (I) + P200 (G) + 150 (X)

Or

Total Leakages < Total injections

P50 (S) + P200 (T) + $125 (M) <P75 (I) + P200 (G) + P150 (X)

The effects of disequilibrium vary according to which of the above equations they
belong to.

If S + T + M > I + G + X the levels of income, output, expenditure and employment will
fall 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 a
boom or expansion in economic activity.

To manage this problem, if disequilibrium were to occur in the five sector circular flow of
income model, changes in expenditure and output will lead to equilibrium being
regained. An example of this is if:

S + T + M > I + G + X the levels of income, expenditure and output will fall causing a
contraction 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 in
taxation and with a lower income they will spend less on imports. This will lead to a fall
in the leakages until they equal the injections and a lower level of equilibrium will be the
result.

The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the
levels of income, expenditure and output will greatly rise causing a boom in economic
activity. As the households income increases there will be a higher opportunity to save
therefore saving in the financial sector will increase, taxation for the higher threshold will
increase and they will be able to spend more on imports. In this case when the leakages
increase they will continue to rise until they are equal to the level injections. The end
result of this disequilibrium situation will be a higher level of equilibrium.

Significance of Study of Circular Flow of Income

1.Measurement of National Income- National income is an estimation of aggregation of
any of economic activity of the circular flow. It is either the income of all the factors of
production or the expenditure of various sectors of economy. However, aggregate
amount of each of the activity is identical to each other.

2.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 infacts restricts the amount of production and income.

3.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.

4.Injections and Leakages Reference- A General Approach to Macroeconomic Policy.

Difference between Real Flow and Money Flow

1. Real flow is the exchange of goods and services between household and firms
whereas money flow is the monetary exchange between two sectors.

2. In real flow household sector supplies raw material, land, labour, capital and
enterprise to firms and in return firms sector provides finished goods and services to
household sector. Whereas in money flow, firm sector gives remuneration in the form of
money to household sector a wages and salaries, rent, interest etc.

3. Difficulties of barter system for the exchange of goods and factor services between
households and firms sector in real flow, whereas no such difficulty or inconvenience
arise in money flow.

4. When goods and services flow from one sector of the economy to another, it is
known as real flow.

Phases or Stages of Circular Flow of Income

Production, consumption expenditure and generation of income are the three basic
economic activities of an economy that go on endlessly and are titled as circular flow of
income. Production gives rise to income, income gives rise to demand for goods and
services ; such a demand gives rise to expenditure and expenditure induces for further
production. The whole process forms the basis for circular flow of income and related
activities- production, income and expenditure are known as phases or stages of
circular flow of income.

Production → Income → Expenditure → Production.

1. Production Phase- Production means creation of utility to satisfy human wants. It
involves the co-ordination of all the factors of production in some desired ratio. This job
is performed by a producer or firm who takes an initiative with the motive of earning
profits. He hires land, labour, capital and an organization and makes them payment in
the form of rent, wages and salaries and interest. This phase is to produce goods and
services and after selling them, it generates income.

2. Income Phase- Producing firms earn revenue from the sale of goods and services
produced by them. Whole of the earning is divided between factors provided by
household sector in the form of rent, wages, interest and profits. Such an income is
classified into three parts:- •Compensation of employees- Wages, salaries, commission,
bonus etc. •Operating Surplus- Profits, rent, interest, royalty etc. •Mixed Income- Income
of self- employed Thus production takes the shape of income of household sector.

3. Expenditure Phase- Household sector spends its income to satisfy unlimited and
recurring human wants. Any saving out of total income takes the shape of investment
on capital goods that helps in generating the income of the economy. Expenditure
becomes the income of producing sector that promotes further the uninterrupted flow of
income.

Gross national income

The Gross national income (GNI) consists of: the personal consumption expenditure,
the gross private investment, the government consumption expenditures, the net
income from assets abroad (net income receipts), and the gross exports of goods and
services, after deducting two components: the gross imports of goods and services, and
the indirect business taxes.

The GNI is similar to the gross national product (GNP), except that in measuring the
GNP one does not deduct the indirect business taxes.

GNI versus GDP

For example, the profits of a Philippines-owned company operating in the UK will only
count towards PHL GNI and UK GDP. If a country becomes heavily indebted, and pays
large amounts of interest to service this debt, this will be reflected in a decreased GNI
but not a decreased GDP. If a country sells off its resources to entities outside their
country 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 debt
and decreasing assets.

GNP is a concept that goes hand in hand with GNI, GDP, and NNI. In contrast to the
GNI, the GNP does not account for the balance of cross-country income, such as
interest and dividends. In contrast to the GDP, the GNP account for the values of
products and services based on citizenship of the owners rather than the territory of the
activity

How to Calculate the GNI

GNI is an add up of Net Income from abroad and the GDP, one can calculate the GNI
by the following formula.

Measures of national income and output

A variety of measures of national income and output are used in economics to estimate
total 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 with
counting the total amount of goods and services produced within some "boundary”

The boundary is usually defined by geography or citizenship, and may also restrict the
goods and services that are counted. For instance, some measures count only goods
and services that are exchanged for money, excluding bartered goods, while other
measures may attempt to include bartered goods by imputing monetary values to them.

National accounts

Arriving at a figure for the total production of goods and services in a large region like a
country entails a large amount of data-collection and calculation. Although some
attempts 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, only
began in the 1930s, in the United States and some European countries. The impetus for
that major statistical effort was the Great Depression and the rise of Keynesian
economics, which prescribed a greater role for the government in managing an
economy, and made it necessary for governments to obtain accurate information so that
their interventions into the economy could proceed as well-informed as possible.

Market value

In 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 service
is 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 and
services produced: the product (or output) method, the expenditure method, and the
income 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

output of that second industry, to avoid counting the item twice we use not the value
output by each industry, but the value-added; that is, the difference between the value
of what it puts out and what it takes in.

The total value produced by the economy is the sum of the values-added by every
industry.

The expenditure method is based on the idea that all products are bought by somebody
or some organisation.

Therefore we sum up the total amount of money people and organisations spend in
buying things.

This amount must equal the value of everything produced. Usually expenditures by
private individuals, expenditures by businesses, and expenditures by government are
calculated separately and then summed to give the total expenditure. Also, a correction
term must be introduced to account for imports and exports outside the boundary.

The income method works by summing the incomes of all producers within the
boundary. Since what they are paid is just the market value of their product, their total
income must be the total value of the product. Wages, proprieter's incomes, and
corporate profits are the major subdivisions of income.

The output approach

The output approach focuses on finding the total output of a nation by directly finding
the total value of all goods and services a nation produces.

Because of the complication of the multiple stages in the production of a good or
service, only the final value of a good or service is included in the total output. This
avoids an issue often called 'double counting', wherein the total value of a good is
included several times in national output, by counting it repeatedly in several stages of
production. In the example of meat production, the value of the good from the farm may
be P10, then P30 from the butchers, and then P60 from the supermarket. The value that
should be included in final national output should be P60, not the sum of all those
numbers, P100. The values added at each stage of production over the previous stage
are respectively P10, P20, and P30. Their sum gives an alternative way of calculating
the value of final output.

Formulae:

GDP(gross domestic product) at market price = value of output in an economy in the
particular year - intermediate consumption

NNP at factor cost = GDP at market price - depreciation + NFIA (net factor income from
abroad) - net indirect taxes

The income approach

The income approach equates the total output of a nation to the total factor income
received 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 has
stockholders, they own the residual, some of which they receive as dividends. Profit
includes the income of the entrepreneur - the businessman who combines factor inputs
to produce a good or service.

Formula

NDP at factor cost = Compensation of employees + Net interest + Rental & royalty
income + Profit of incorporated and unincorporated NDP at factor cost.

The expenditure approach

The expenditure approach is basically an output accounting method. It focuses on
finding the total output of a nation by finding the total amount of money spent. This is
acceptable, because like income, the total value of all goods is equal to the total amount
of money spent on goods. The basic formula for domestic output takes all the different
areas in which money is spent within the region, and then combines them to find the
total output.

Where:
C = household consumption expenditures / personal consumption expenditures
I = gross private domestic investment
G = government consumption and gross investment expenditures
X = gross exports of goods and services
M = gross imports of goods and services

Note: (X - M) is often written as XN, which stands for "net exports"

GDP and Gross domestic product (GDP) is defined as "the value of all final goods and
services produced in a country in 1 year".

Gross National Product (GNP) is defined as "the market value of all goods and services
produced 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 the
United States:

National income and output (Billions of dollars)
Period Ending 2003
Gross 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 -273.9
Gross domestic product 11,008.1
Private consumption of fixed capital 1,135.9
Government consumption of fixed capital 218.1
Statistical discrepancy 25.6
National 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 welfare

GDP per capita (per person) is often used as a measure of a person's welfare.
Countries with higher GDP may be more likely to also score highly on other measures
of welfare, such as life expectancy. However, there are serious limitations to the
usefulness 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
nanny's income contributes to GDP, but an unpaid parent's 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

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) are
used.

Difficulties in Measurement of National Income

There are many difficulties when it comes to measuring national income, however these
can 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

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 don't 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.

Circular flow

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