Circular Flow of Economics

2. Introduction

Macroeconomics is the branch of economics that studies the economic behaviour of all the agents in
the economy; i.e. it is the study of the economy as a whole. In other words, macroeconomics is the
study of aggregate outcomes of the decisions taken by the different agents in an economy.

To begin the study of basic macroeconomics let us introduce the concept of the circular flow of
Income. The circular flow of income forms the basis for all the macroeconomic models of the
economy and it is imperative to understand the circular flow model for understanding essential
concepts like national income, aggregate demand and aggregate supply.

The circular flow of income describes the movement of goods or services and income among the
different sectors of the economy. It illustrates the interdependence of the sectors and the markets
to facilitate both real and monetary flow.

The real flow refers to the flow of factor services and flow of goods and services. The flow of factor
services from the households to the firms and the flow of goods and services from firms to the
household is the real flow. The flow of factor services generates money flows i n the form of factor
payments which the firms pay the household and similarly the household need to pay the firms for
the flow of goods and services. The movement to the money/cash payment from one sector to the
other sector corresponding to the real flow is referred to as the monetary flow. Thus, the income of
one sector becomes the expenditure of the other and the supply of goods and services by one sector
becomes the demand of the other sector. The real flow and monetary flow move in a circular
manner in an opposite direction. A continuous flow of production, income and expenditure is known
as the circular flow of income.

3. The Four Macroeconomic Sectors

3.1 The Household Sector

This sector includes all the individuals in the economy. The primary function of this sector is to
provide the factors of production. The factors of production include land, labour, capital and
enterprise. The household sectors are the consumers who consume the goods and services
produced by the firms and in return make payments for the same.

3.2 The Firms Sector

This sector includes all the business entities, corporations and partnerships. The primary function of
this sector is to produce goods and services for sale in the market and make factor payments to the
household sector.

3.3 The Government Sector

This sector includes the center, state, and local governments. The prime function of this sector i s to
regulate the functioning of the economy. The government sector incurs both revenue as well as
expenditure. The government earns revenue from tax and non-tax sources and incurs expenditure
for provide essential public services to the people.

3.4 The Foreign Sector

This sector includes transactions with the rest of the world. Foreign trade implies net exports
(exports minus imports). Exports include goods and services produced domestically and sold to the
rest of the world and imports include goods and services produced abroad and sold domestically.
4. The Three Markets

4.1 The Goods Market

In this market the goods and services are exchanged among the four macroeconomic sectors. The
consumers are the household, government and the foreign sector while the producers are the firms.

4.2 The Factor Market

The factors of production are traded through this market. For the production of final goods and
services, the firms obtain the factor services and make payments in the form of rent, wages and
profits for the services to the household sector.

4.3 The Financial Market

This market consists of financial institutions such as banks and non-bank intermediaries who engage
in borrowing (savings from households) and lending of money.

5. The Circular Flow of Income in a Two-Sector Model

In this model, the economy is assumed to be a closed economy and consists of only two sectors, i.e.,
the household and the firms. A closed economy is an economy that does not participate in
international trade. In this model, the household sector is the only buyer of the goods and services
produced by the firms and it is also the only supplier of the factors of production. The household
sector spends the entire income on the purchase of goods and services produced by the firms
implying that there is no saving or investment in the economy. The firms are the only producer of
the good and services. The firms generate income by selling the goods and services to the household
sector and the latter earns income by selling the factors of production to the former. Thus , the
income of the producers is equal to the income of the households is equal to the consumption
expenditure of the household. The demand of the economy is equal to the supply.

In this model, Y = C

Where, Y is Income and C is Consumption.

The circular flow of income in a two sector model is explained with the help of the following
diagram, called Model 1.
5.1 The Circular Flow of Income in a Two- Sector Model with Saving and Investment

In the above model, we assumed that the household sector spends its entire income and that there
is no saving in the economy however, in practice, the household sector does not spend all its
income; it saves a part of it. The saving by the household sector would imply monetary withdrawal
(equal to saving) from the circular flow of income. This would affect the sale of the firms since the
entire income of the household would not reach the firm implying that the production of goods and
services would be more than the sale. Consequently, the firms would decrease their production
which would lead to a fall in the income of the household and so on. There is one way of equating
the sales of the firms with the income generated; if the saving of the household is credited to the
firms for investment then the income gap could be filled. If the total investment (I) of the firms is
equal to the total saving (S) of the household sector then the equilibrium level of the economy
would be maintained at the original level. This is explained with the help of the following di agram,
called Model 1a.

The equilibrium condition for a two-sector model with saving and investment is as follows:

Y = C + S or Y = C + I or C + S = C + I

Or, S = I

Where, Y = Income, C = Consumption, S = Saving and I = Investment

6. The Circular Flow of Income in a Three – Sector Model

The three sector model of circular flow of income highlights the role played by the government
sector. This is a more realistic model which includes the economic activities of the government
however; we continue to assume the economy to be a closed one. There are no transactions with
the rest of the world. The government levies taxes on the households and the firms and it also gives
subsidies to the firms and transfer payments to the household sector. Thus, there is income flow
from the household and firms to the government via taxes in one direction and there is income
outflow from the government to the household and firms in the other direction. If the government
revenue falls short of its expenditure, it is also known to borrow through financial markets. This
sector adds three key elements to the circular flow model, i.e., taxes, government purchases and
government borrowings. This is explained with the help of the following diagram called, Model 2.

In this model, the equilibrium condition is as follows:

Y= C+ I+ G

Where, Y = Income; C = Consumption; I = Investment and G = Government Expenditure

In a closed economy, aggregate demand is measured by adding consumption, investment and

government expenditure. Thus, aggregate demand is defined as the total demand for final goods
and services in an economy at a given time and price level and aggregate supply is defined as the
total supply of goods and services that the firms are willing to sell in an economy at a given price
level.
7. The Circular Flow Of Income in a Four Sector Model

This is the complete model of the circular flow of income that incorporates all the four
macroeconomic sectors. Along with the above three sectors it considers the effect of foreign trade
on the circular flow. With the inclusion of this sector the economy now becomes an ‘open economy’.
Foreign trade includes two transactions, i.e., exports and imports. Goods and services are exported
from one country to the other countries and imports come to a country from different countries in
the goods market. There is inflow of income to the firms and government in the form of payments
for the exports and there is outflow of income when the firms and governments make payments
abroad for the imports. The import payments and export receipts transactions are done in the
financial market. This is explained with the help of a following diagram, called Model 3.

In this model, the equilibrium condition is as follows:

Y = C + I + G + NX

NX = Net Exports = Exports (X) – Imports (M)

Where, Y = Income; C = Consumption; I = Investment; G = Government Expenditure; X = Exports and

M = Imports.

8. Leakages and Injections in the Circular Flow of Income

The flow of income in the circular flow model does not always remain constant. The volume of
income flow decrease due to the leakages of income in the circular flow and similarly, it increases
with the injections of income into the circular flow.

Leakages: A leakage is referred to as an outflow of income from the circular flow model. Leakages
are that part of the income which the household withdraw from the circular flow and is not used to
purchase goods and services. This part of the income does not go to the goods market. There are
three main leakages and these are:

Saving: It is that part of the income that is not used by the household to purchase of goods and
services or pay taxes. It is kept with the financial institutions like banks that can be len d further by
the banks to the firms for investment or capital expansion purposes.

Taxes: Tax revenue is the income paid by the household and firms to the government. It flows to
the government rather that the goods market.

Imports: Import payments are made to the foreign sector for the good and services bought from
them. This is an outflow of income from the economy.

Thus, we see that leakages reduce the volume of income from the circular flow of income.

Leakages = S + T + M

Where, S = Saving; T = Taxes; and M = Imports

Injections: An injection is an inflow of income to the circular flow. The volume of income increases
due to an injection of income in the circular flow. There are three main injections and these are:

Investment: It is the total expenditure by the firms on capital expansion. It flows to the goods
market.

Government Expenditure: It is the total expenditure of the government on goods and services,
subsidies to the firms and transfer payments to the household sector. Transfer payments are
government payments like social security schemes, pensions, retirement benefits, and temporary
aid to needy families etc.

Exports: Export receipts are the payment made by the foreign sector for the purchase of domestic
goods. It is an inflow of income from the foreign sector to the financial market.

Injections = I + G + X

Where, I = Investment; G = Government Expenditure; and X = Exports

Balance of leakages and Injections in an open economy is; S + T + M = I + G + X

Or, (S –I) = (G – T) + (X – M)

The leakages and injections can be shown with the help of the following diagram called, Model 4.

Model 4: The Leakages and Injections in the Circular Flow of Income