CHAPTER 2: CIRCULAR FLOW OF INCOME IN ECONOMY

Introduction

The entire economy works like a simple machine. It consists of three sectors – households, business and
government. Several transactions take place among these sectors over and over again millions of times.
These transactions are governed by the self-interest principle of Adam Smith. That is while people are
producing goods and services out of their own self-interest to generate incomes and benefit themselves, at
the same time it benefits everyone. The founding premise is “one man’s expenditure is another man’s
income”.

A transaction is an exchange of goods or services for money. The entire economy works through these
transactions. This is the famous, “circular flow of income” diagram. This chapter explains how such
transactions take place between the three sectors illustrating the functioning of an economy.

Essentially, all these flows happen within a conduit – a pipe. Very much like how water flows through a
pipe, income flows through this conduit. Just like a water pipe can develop leakages and would need
injections to prevent the water from draining out completely, so too the income pipe can develop leakages
and would require injections to prevent itself from emptying out.

Circular Flow of Income in a Two Sector Economy

In the basic two sector economy, there are only two actors – households and businesses. The household
sector represents the consumers – that is those who buy and consume goods and supply factor services
such as land, labor, capital and organization.
 Chart 1: Circular Flow of Incomes – Two Sector Model

The business sector consists of the producers – that is those who produce goods and sell them to the
household in return for money. At the same time, to produce these goods and services they hire the factor
services of the household sector and pay them rewards in terms of rent for land, wages for labor, interest
for capital and profit for organization.
In this pipe which is closed, the income circulates continuously and is recycled.

For instance, in the first round, the businesses hire the factor services of households and pay them factor
incomes. Households in return receive these incomes and use them to buy the goods and services. This is
received as income by the businesses. In the second round, the businesses use these incomes to again hire
the factor services of the households to produce more goods and services. Households again receive these
incomes and use them to buy back the goods and services which is recirculated round after round. The
underlying principle is “one man’s expenditure is another man’s income”.

Both business and households play a very critical role in the economy and the underlying transactions
constitute a significant portion of the country’s GDP.

Two-Sector model with Consumption, Savings and Investment Functions

In this basic model, the income keeps circulating within the pipe. But is it practical to assume that the
households will spend all the incomes that they receive? Will they not try to save for the rainy day? What
happens then? Savings is a leakage. Let us for example, assume that in the first round, the businesses
hired factor services and produced goods worth Rs 100 crores. The households received incomes equal to
these Rs. 100 crores in terms of rent, wages, interest and profits. But now they do not spend the entire Rs.
100 crores but only spend Rs. 80 crores, while saving the remaining Rs. 20 crores. That means business
are now receiving Rs. 20 crores less which reduces their investment to only Rs. 80 crores. That means
they are producing only Rs. 80 crores worth of goods and paying out incomes of only Rs. 80 crores. In the
second round another Rs. 20 crores is saved which reduces their incomes and investments only to Rs. 60
crores.

If it proceeds this way, then by the end of the fifth round the income will become zero and the “pipe” will
dry out. The savings are termed as “leakage”, much like a leakage in a water pipe. And just like how we
try to tap the water in the leakage with the help of a bucket, similarly, we need a “bucket” to tap the
savings leakage.

The “bucket” here is the banks, financial markets and other financial institutions which collect these
savings. They act as financial intermediaries, pool these savings and lend it back to the businesses which
helps them to invest it back in the economy. The investments amount to an injection. In the above
example, every time a leakage of Rs. 20 crores of savings happen, banks and other institutions tap them,
lend it to the businesses who again put it back in the pipe as an investment, so that the total income once
again amounts to Rs. 100 crores. So, effectively, round after round, even if savings leakages happen,
investments will refill them, so that the pipe will never dry out. The following figure illustrates this
concept.
 Chart 2: Circular Flow of Incomes – Two Sector Model

With Savings and Investment Function

We will denote the income, consumption, savings and investment equations as follows:

Y = C + I (Income Equation) or
Where Y is income, C is consumption and I is income.
Y=C+S
S = f (Y) (Savings Function) or
Where S is savings and Y is income
S = Y – C and
S I
I = f (i) (Investment function)
Where I denote investment and i denotes rate of interest.

Here, in the income equation, income is a sum of consumption and investment. That is for income to
increase or decrease, either/both savings and investment will have to increase or decrease.

As far as the savings function is concerned, savings is a direct function of income. Higher the income,
more money will be saved. Lower the income, less the amount that will be saved. Or alternatively savings
is income, less consumption. That is the excess of income over consumption is savings. Also, savings by
definition is equal to investment.
 In case of investment, investment is inversely related to the rate of interest. That is higher the rate of
interest, lower will be the money borrowed and invested. This is because businesses will find it more
expensive to borrow credit at higher rates of interest since it pushes up their financing costs. Similarly,
lower the interest rate, higher will be the investment since companies find it cheaper to borrow money.

Chart 3: Circular Flow of Incomes – With Financial Sector

Circular Flow of Income in a Three Sector Economy

In the three-sector economy, we now include government. Government as an economic actor creates a
leakage – taxes. It collects these taxes from both - businesses as corporate tax and from households as
income tax.

However, it ploughs back these taxes into the economy in the form of government expenditure. Govt.
expenditure plays a crucial role in the economic development of a country.

In national income accounting, government expenditure refers to govt. spending on buying goods and
services for current use to meet the economy’s needs. It includes both public spending and public
investment and transfer payments. Examples of govt. spending include its various welfare schemes,
developmental programs, providing public goods such as police, hospitals, public libraries, etc.

Public investment refers to producing capital goods which will result in future consumption. Examples
include, public sector undertakings, infrastructure development such as building roads, bridges, dams,
railways, airports, etc. the government finances its spending through the taxes that it receives. In case of
shortfall, that is if expenditure is more than tax revenue, which is often the case, it will resort to
borrowing to fill the gap. Transfer payments include pensions, scholarships, subsidies, etc.

Again, the same principle of “one man’s income is another man’s expenditure” operates here as well.
Every rupee that the government spends is received by the people who in turn use them to buy goods and
services.

The national income equation including the government now becomes

Y=C+I+G

Where Y is income, C is consumption representing households, I is investment representing

Circular Flow of Income in a Four Sector Economy

The four-sector economy comprises businesses, households, govt and rest of the world. Rest of the world
means external economy – that is foreign sector. Rest of the world also creates transactions in terms of
trade flows and capital flow. The leakage to the RoW consists of imports – that part of income which is
paid out to foreigners for purchasing goods and services from them. The corresponding injection for this
is exports – that money that we receive from foreigners on account of selling goods and services to them.
The capital flows include inflows such as foreign direct investment and foreign institutional investment
made by foreigners in India, while outflows include foreign direct investment and foreign institutional
investment made by Indians abroad. Again, the principle is one man’s expenditure is another man’s
income because foreigners not only receive money from us for these transactions but also pay us in
exchange of goods, services and capital provided to them. The national income equation with the
inclusion of the rest of the world now looks as:

Y = C +I + G + X – M

Where Y stands for income, C for consumption, I for investment expenditure, G for govt. expenditure and
X-M is exports less imports – that is net of foreign trade. Chart 4 denotes the inter-relationships between
these four actors.

For instance, as the opening case illustrates, China adopted an aggressive export strategy which resulted
in rapidly increasing its national income, so that its much ahead of India in economic development. Many
South East Asian economies including Japan, have successfully adopted these strategies to achieve
miraculous results. However, too much dependence on the foreign sector can result in huge external
shocks. For example, if a country on whom we are heavily dependent on for exports suddenly stops
selling them then it can create a potential crisis for us. One such example is the Gulf oil crisis which
resulted in India adopting the New Economic Policy 1991.

In all these models, the fundamental idea is that all these actors are carrying out transactions which
generate income flows and produce goods and services. The market forces of demand and supply will
determine what goods and services will be produced, how they are produced – that is through capital
intensive or labor-intensive techniques, how much is produced, and how will the total output be
distributed.

In a capitalist economy, while the private sector decides the answers to these questions, in socialism the
state will answer these questions.
 Chart 4: Circular Flow of Incomes – Four Sector Model

Summary

 In the basic two sector economy, there are two actors – households and businesses. The
household sector represents the consumers – that is those who buy and consume goods and
supply factor services such as land, labor, capital and organization.
 The business sector consists of the producers – that is those who produce goods and sell them to
the household in return for money. At the same time, to produce these goods and services they
hire the factor services of the household sector and pay them rewards in terms of rent for land,
wages for labor, interest for capital and profit for organization.
 The underlying principle is “one man’s expenditure is another man’s income”.
 If savings were to increase – which constitute a leakage, without the corresponding “injection” -
investment, the circular flow of incomes would soon be exhausted and there will be no more
money to circulate in the economy.
 The “bucket” here is the banks, financial markets and other financial institutions which collect
these savings. They act as financial intermediaries, pool these savings and lend it back to the
businesses which helps them to invest it back in the economy.
 In the income function, income is a direct function of consumption and investment. Savings is a
direct function of income. Investment is inversely related to the rate of interest.
 In the three-sector economy, government constitutes the third agent. Government as an economic
actor creates a leakage – taxes. It collects these taxes from both businesses as corporate tax and
from households as income tax.
 However, it ploughs back these taxes into the economy in the form of government expenditure.
Govt. expenditure plays a crucial role in the economic development of our country.
  The four-sector economy comprises businesses, households, govt and rest of the world. Rest of
the world means external economy – that is outside that of the domestic economy. Rest of the
world also creates transactions in terms of trade flows and capital flow.
 The leakage to the RoW consists of imports – that part of income which is paid out to foreigners
for purchasing goods and services from them. The injection for this is exports – that money that
we receive from foreigners on account of selling goods and services to them. The capital flows
include inflows such as foreign direct investment and foreign institutional investment made by
foreigners in India, while outflows include foreign direct investment and foreign institutional
investment made by Indians abroad.
 While external sector plays a crucial role in the economic development of a country, it has its
downside. This is best evidenced by the rapid rise and fall of the South East Asian economies.

Descriptive Questions

1. Discuss the underlying transactions and flow of incomes in the two sector model, with the help of a suitable
diagram.
2. Discuss the underlying transactions and flow of incomes in the three sector model, with the help of a
suitable diagram.
3. Discuss the underlying transactions and flow of incomes in the four sector model, with the help of a
suitable diagram.
4. Define the income, consumption, investment and savings functions.