Circular flow of income

By: Anuj Aggarwal

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 interdependent 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.

Firms and Households

Provide consumers with goods and services in exchange

for consumer expenditure and "factors of production"
from households.

In this process, household sector provides various factors

of production such as land, labor, capital and enterprise to
producers who produce goods and services by
coordinating them. Producers or business sector in return
makes payments in the form of rent, wages, interest and
part of 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.

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.

Two-Sector Economy
(When All Income is Consumed)
Wages and
Profits (i.e.
income (Y)
Rs.1000

Productive
Sector

Household
Sector

AtEquilibrium :
Y AD
AD C
Y C

Private
Consumption (C)
Rs.1000

Three Sector Model

It includes household sector, producing sector and

government sector. It studies a circular flow income in
these sectors excluding rest of the world i.e. closed
economy income.

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
unending.

Closed Economy
Wages and
Profits (i.e.
income (Y)
Rs.1000

AtEquilibrium :
Household
Sector

Productive
Sector

Y AD
AD C S C I
InEquilibrium
SI

Private
Consumption
(C) Rs.800
Investment
Rs.200

Savings (S)
Rs.200
7

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.

A residual of each market comes in capital market as

saving which in turn is invested in firms and
government sector.

Circular Flow of Income

Y=C+I+G+X-M

Five sector model

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.

Five sector model

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 the sum of total leakages does not
equal the sum of total injections.

Disequilibrium can be shown as:

S+T+MI+G+X

Significance of Study of
Circular Flow of Income
1.Measurement of National Income- National
income is an estimation of aggregation of
economic activity. It is either the income of all
the factors of production or the expenditure of
various sectors of economy.
2.Knowledge of Interdependence- Circular flow of
income signifies the interdependence of each
activity upon one another. If there is no
consumption, there will be no demand and
expenditure which restricts the amount of
production and income.

Difference between Real

Flow and Money Flow

Real flow is the exchange of goods and services

between households and firms whereas money
flow is the monetary exchange between two
sectors.

In real flow, household sector supplies raw

material, land, labour, capital and enterprise to
firms and in return business 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 via wages and salaries, interest etc.

Thankyou