A fantastic PPT on the topic circular flow of income. It gives a complete understanding of the working of an economy in two sector, three sector and four sector models. It explains how production, income and expenditure are interrelated and how they move in a circular way.

1. (10 Marks)
Chapter-1
Circular Flow of
Income
Unit - 1

2. Introduction
• An economy consists of basic economics
activities of production, consumption and
investment.
• These are vital processes of the
economy because these are the basis of
survival and growth of an economy.
• In carrying out these activities, producers
produce goods and services, consumers buy
these goods and services and thereby
generate income.

3. ● Income generated in the production
process flows in a circular order.
● It is called a circular flow as this is a
continuous process; there is no end to it
because there is no end to human wants.
● Level of economic activity causes income
and product to flow in a circular manner.

4. Stock and Flow Concepts
Basis Stock Concept Flow Concept
1. Meaning
2. Nature
3. Time
Period
4. Example
It is that quantity of
economic variable
which is measured at a
particular point of
time.
Static in nature.
It has no time
dimension.
Money supply, national
wealth, capital,
quantity of rice stored
etc.
It is that quantity of
economic variable
which is measured
during a period of
time.
Dynamic in nature.
It is time dimension
such as per day, per
week, per month, per
year etc.
National Income,
interest on capital,
capital formation etc.

5. ● An economy provides a living to the
people for satisfaction of their wants.
● The main aim of economic activities is to
create wealth.
● It is also concerned with use of scare
resources to satisfy the maximum
unlimited human wants.
● To satisfy human wants every economy
performs three basic activities which are
discussed below:-
Basic Economic Activities

6. 1. Production – Production is generally defined as
an activity which produces physical goods and
services.
● In other words, production is the process of
converting inputs into outputs or value added to
the raw materials.
Output = f (Inputs)

7. 2. Consumption – The process of using up utility
value of goods and services for direct
satisfaction of individual or collective human
wants is called consumption.
● The households consume a large number of
goods such as food, milk etc. and services
like those of doctors, lawyers etc. to satisfy
individual wants.

8. 3. Capital Formation (Investment) – It is the
addition to the existing capital stock of an
economy during year.
● The part of production (income) which is not
used (expenditure) during a year is
investment.
● Capital formation involves production of
more capital goods like dams, roads,
machines etc. which are used for further
production of goods and help in accelerating
growth.

9. * Change in production will cause change
in consumption or capital formation.
Thus, these activities are interrelated
and lead to emergence or circular flow
of income.
Δ in
Production
Δ in
Income
Δ in
Consumption
Δ in
Savings
Δ in
Investment
Δ in
Expenditure

10. Circular Flow of Income
● In carrying out economic activities like
production, consumption and exchange,
people are involved in making transactions
between different sectors of economy
because of these transactions income and
expenditure move in a circular form in an
economy. This is called circular flow of
income.
● In other words, circular flow of income
refers to flow of money income or flow of
goods and services across different sectors
of the economy in the circular form.

11. From Macro point of view, economy is often
divided into four sectors:
1. Household Sector – It includes consumers
of goods and service. Households are the
owners of the factors of production and
provide factor services to the producer
sector.
2. Producer/Firm Sector – This sector includes
all producing units or firms in the economy.
To produce goods and services, the firms
hire factors of production (land, labour,
capital and entrepreneur) from the
households and sell goods and services.

12. 3. Government Sector – This sector produces
goods and services for collective
consumption. For example – services of
roads, dams, defence etc. Here, government
promotes the well being of the citizens.
4. External Sector/ Foreign Sector – This is
also called rest of the world sector. It is
engaged in export and import of goods and
services and the flow of loans and
investment between the domestic economy
and other countries of the world.

13. Phases/Stages of Circular
Flow of Income
(i) Phase of Production – It refers to the
process of value addition by the producing
sector.
● The producer sector hires factor
services from the household sector and by
using other non factor inputs, goods and
services are produced.
● It is also known as Generation Phase.
* As there is no end to human wants there
is no end to the process of production also.

14. (ii) Phase of Income Generation – For
providing their factor services to the
producers, the households get factor
payments.
● In this phase of circular flow, there is
generation or distribution of income as an
outcome of production of goods and
services.
● It is also known as Distribution Phase.
● Value of production is converted into
factor income after monetary value of
goods and services is distributed among
factors of production.

15. (iii) Phase of Expenditure/Disposition
Income is spent on purchase of final
goods and services.
● When households purchase the final
goods, there is consumption expenditure.
● When the producers purchase the final
goods, there is investment expenditure.
● Thus in this phase, there is disposition of
income as an outcome of generation of
income.

16. ● Expenditure generates demand for goods
and services; this causes production of
goods and services and consequently,
generation of income.
● Thus, the three flows of production, income
and expenditure move in a circle. That is
why; it is called the circular flow.

17. Types of Circular Flow
1. Real Flow – Real Flow implies the flow of
factor services from households to firms and
goods and services from firm to household.
● In simple words, real flow refers to flow of
goods and services.
● It is also known as product flow/physical
flow.

18. 2. Money Flow – It refers to the flow of
money across different sectors of the
economy.
● In other words, money flow refers to flow
of money in the form of factor payments and
consumption expenditure among different
sectors.
● It is also known as nominal flow/income flow.

19. Difference between Real Flow
and Money Flow
Basis Real Flow Money Flow
1.Meaning
2.Nature
3.Nature
of Flow
It refers to flow of
goods and services
across different
sectors of the economy.
It is flow of physical
output.
It is also known as
physical flow or product
flow.
It refers to the flow of
money across different
sectors of the economy.
It is flow of monetary
transactions.
It is also known as
monetary flow or nominal
flow.
Note:
• Real flows are opposite to money flows.
• In any exchange process, the producer receives
the same amount, what consumer spends.

20. Models/Forms of Circular Flow
of Income
I. Circular Flow Model in Simple Economy
(Two Sector Model without Saving)
Assumptions
(i) There are only two sectors (i.e. household
and firm).
(ii) There is no saving.
(iii) There is no Govt. sector.
(iv) There is no rest of the world (ROW)
sector.

21. • Factor services flow from household sector to the
producer sector (real flow).
• Factor payments flow from producer to household
sector for their services (money flow).
• Final goods and services flow from producer to the
household sector (real flow).

22. • Final consumption expenditure on goods and
services flow from household to producer
sector (money flow) in exchange of goods and
services.
Conclusions:
1. Real Flow = Money Flow
2. Total Production = Total Consumption
3. Factor Payments = Factor Income
4. Factor Income = Consumption Expenditure
5. Consumption Expenditure by Households =
Total Income of the Producers.

23. II. Circular Flow Model in Two Sector
Economy With Financial Sector (Two
Sector Model with Saving)
Assumptions
(i) There are only two sectors (i.e. household
and firm).
(ii) There is no Govt. sector.
(iii) There is no rest of the world (ROW)
sector.
• Financial system is essential for the
working of modern economy.
• Financial institutions are intermediaries
between savers and investors.

24. • In reality household do not spend entire
income on consumption. They save part of their
income.
• Similarly, firms may not distribute all their
receipts to household; they may save a part of
their receipts in the forms of undistributed
profits.

25. • Factor services flow from household
sector to the producer sector (real flow).
• Factor payments flow from producer to
household sector for their services
(money flow).
• Final goods and services flow from
producer to the household sector (real
flow).
• Final consumption expenditure on goods
and services flow from household to
producer sector (money flow) in exchange
of goods and services.

26. • Household sector and producer sector
save and put savings in financial system.
• Household sector and producer sector
borrow from the financial sector.
Conclusions:
1. Real Flow = Money Flow
2. Total Production = Total Consumption
3. Factor Payments = Factor Income
4. Consumption Expenditure by Households =
Total Income of the Producers.

27. Expansion and Contraction of
Circular Flow: Injections and
Leakages
• A circular flow of income may expand or
contract. Expansion of circular flow of income
implies a rise in the level of income/output in
the economy.
• Contraction of circular flow of income, on the
other hand, implies a fall in the level of
income/output in the economy.
• Expansion of circular flow occurs owing to
‘injections’, while contraction occurs owing to
‘leakages’.

29. Leakages Injections
1.These flow variables
have a negative impact
on the process of
production or income
generation.
2.These are withdrawals.
3. Effect on economy -
(a) Reduce flow of
income/production.
(b) Reduce demand of
goods and services.
▪ Examples: saving,
taxation and imports
1.These cause positive
impact on the process
of production or income
generation.
2.These are additions .
3. Effect on economy –
(a) Add to the production
capacity of the economy.
(b) Generate demand of
goods and services.
▪ Examples: investment,
exports, consumption
expenditure.

30. Importance/ Significance of
Circular Flow of Income
1. Knowledge of interdependence among
sectors – It helps us to understand inter
dependence among different sectors of the
economy.
2. Identification of injections and leakages
These help in maintaining the identity among
production, income and expenditure. If
there are leakages, circular flow reduces and
if there are injections, circular flow
expands.

31. 3. Estimation of National Income – National
income is measure by three methods,
production, income and expenditure. The
three phases of circular flow of income give
us the identity among the three methods as
value of goods and services is same as
income generation and income causes
expenditure.
4. Indicator of economic activity – The
circular flow gives explanation on various
macro variables viz. national income,
consumption, saving, employment etc.
Accordingly, level of economic activity can be
ascertained.

33. Presented by –
Ritvik Tolumbia
CS, CWA, M.Com (ABST), M.A (Eco), B.Ed
Author & Faculty of Commerce