circular flow of income
meaning flow of income
it refers to the floe of money income or the flow of goods and services across different sectors of the economy is a circular flow.
it is clear from the diagram in the Ist phase by combining factors of production is done. after that factors get income in the form of wages , rent, dividends and profits. when this income is spent and it generates demand for goods and services which further leads to production. so this process is continued and it is known as "circular flow of income".
phases of circular flow of income
there are three phases of circular flow of income
production phases :- it refers to production of goods and services by the producer . the production is done by combining various factors of production i.e. land, labor, capital and entrepreneur .
income phase :- in this phase factor of production get income in the form of rent , wages, interest , dividends and profits
expenditure phase ;- this phase refers to the expenditure on the purchase of goods and services by the household and the other sectors in the economy . this is money flow form one sector to the other sector.
explain the existence to circularity of flows
production and consumption of goods must continue as an essential condition of human existence. accordingly mutual interdependence between the producers and the consumers. and the consequent mutual exchanges between them must continue.
consumption is a continuous process therefore, households needs goods and services for their survival from the products. implying that the flow of goods and services form the producers to households will always remain as on continuous process .
continuity of producers implies the continuity of consumption and continuity of consumption implies the continuity of production. and continuity of both production and consumption implies the continuity of intersectoral exchanges , which implies continuity of intersectoral flows.
types of circular flow
real flow
monetary flow
1. real flow :- it shows the flow of income in a barter system when goods are exchanged for goods . there is no money in circulation.
it is of two types
factor flow :- flow of factor services form household sector to producing sector .
product flow :- flow of goods and services from producing sector to household sector.
it is clearly shown in the diagram that there are 2 sectors in the economy i.e. household sector and business sector . household sectors provides factor services and in return gets goods and services.
2. monetary flow :- in this money act as medium of exchange and there is a flow of money from one sector to other sector of the economy.
it is of two types :-
expenditure flow :- the flow od expenditure , money spent by household sector on buying goods and services produced by the producer sector.
factor flow income :-the flow income received by household sector in the form of rent , wages, interest and profits as rewards for their factor services.
it is clear from the diagram that household sector provides inputs in the form of rent, labor, capital ,and entrepreneur to the business sector and get payment in the form of rent, wages , interest, and profits. the business sector provides goods and services to the households and gets payments for the goods and services.
circular flow of income in different sectors
two sector model :- on the assumption that there are only sectors in the economy I)household sector ii)producing sector.
three sector model :- on the assumption that there are three sectors in the economy I)household sector ii) producing sector iii) government sector . it is closed economy means in this economy there is no exports and no imports .
four sector model :- on the assumption that there are four sectors in the economy . I) household sector ii) producing sector iii) government sector iv)foreign sector or rest of the world . it is an open economy it means in this economy there is exports and imports exists in the economy.
two sector model of the circular flow of income
household sector :-including consumers of goods and services household are also the owners of the factors of production. it provides factor services to the producing sector and consumes final goods and services produced by it
producing sector :- it produces the final goods and services by making use of the factor services , labor and capital etc.
it is clearly shown in the diagram that in this diagram there are two flows real flow and monetary flow real flow indicates that services of the factors flow from the household sector in this household sector gives the payment in the form of wages, interest, dividend and profit . and producing sector can give the goods and services .
two sector model with saving-investment/financial system
in reality household sector spend all part of its income on consumption . people can save some part of there of income. the total income of household sector can not reach the producing sector in the form of consumption expenditure .
there is one method to increase the sales of firm. expenditure on the production of capital goods . purchase of capital goods is very beneficial for the firms and it is called investment expenditure .
the assumption that the firms distribute all the profits and receipts among the factors as far the truth. the firm can retain some part of their income and receipt as a undistributed profits. saving of firms is called investment . if there saving is equal to reinvestment . household sector also save a part of there saving and it is equal to investment.
three sector model of the circular flow of income
this sector is more close to the reality. income flows from the producing sector and household sector to the government sector in the form of tax. the income received to the government sector in the form of taxes and government sector can spend their revenue on the goods and services and to the sector in the form of remuneration of factor services rendered by the government.
if government can spend their all income on the producing sector and the household sector . the same will flow back to these very sectors in the form of subsidies, transfer payments and other government expenditure.
four sector model of the circular flow of income
it is a real model of circular flow of income . circular is an open economy . in an open economy there are four sectors I)household sector ii) producing sector iii) financial sector iv) government sector v) foreign sector .
in reality there are four sectors in the economy in real life , producing sector, household sector and government sector all saving effect in money terms. this saving is deposited in the capital market. government and producing sector can borrow form the capital market. circular flow of income in capital market which refers to financial institutions like banks and insurance companies .
does circular flow of national income always remain constant?
the circular flow of income is not remain constant. there is some leakages and withdrawals of income from the circular flow due to decrease in the circular flow . on the other hand , it increases with the injections of income into the circular flow.
leakages and withdrawals
a leakage is a outflow or withdrawal of income from the circular flow . this leakage is not passed from one sector to another sector . if factors of production is not spend their income on the goods and services produced it is called withdrawal. if some part of income is earned by firms by selling of goods and not spend that much income on the purchase of services and keep as a undistributed profits it is also called withdrawal and leakages. in other words , income does not flow back to the domestic product market. these are
injections
an injection is a non consumption expenditure. it is an expenditure on the production of goods and services within the domestic territory . but not used on domestic household for consumption purposes. withdrawal reduces the circular flow , injections accelerate it.
investment
government expenditure
exports
collective effect of withdrawals and injections on the circular flow of income
neutral effect or constant circular flow : when the amount of withdrawals and injections are equal there is a equal effect on the circular flow of income.
saving + taxes + imports = investment + government expenditure + exports .
2. positive effect or increase in circular flow : effect on circular flow of income is positive when injection exceeds withdrawals . that is
investment(I) + government (g) + exports (x) > saving (s) + taxes (t)+ imports (m)
3. negative effect or decrease in circular flow : effect of withdrawals and injections on circular flow of income is negative when withdrawals exceeds injection .
S + T+ M > I + G + X
importance of circular flow of income
mutual relation
triple identity of production , income and expenditure
estimate of national income
what is macroeconomics?
macroeconomics is the study of economy as a whole.
important variables of macroeconomics
aggregate consumption :- it means consumption of all goods and services in the economy during the period of an accounting year.
aggregate investment :- it refers to expenditure by all the producers `in the economy on the purchase of such goods which producers can add their stock of capital during the year.
aggregate demand :-it refers to total expenditure on the purchase of all goods and services of all goods and services in the economy during the period of an accounting period .
aggregate supply :-it is the total production of goods and services in the economy during the year.
domestic income :- it means income generated with in the domestic country during the year.
concepts and issues related to macroeconomics
growth and development :-economies need to grow continuously over time and growth (in terms of goods and services) must reflect itself to rise standard of living of the masses or the overall quality of life must be improved.
unemployment :- there is a large scale rural unemployment among the unskilled workers in urban areas . in developed countries it is cyclical in nature and occurs owing to lack of demand for goods and services. its actual means that there are number of workers which are able and willing to work but they have no work.
inflation
inflation means when the price level of all goods and services in he economy tends to rise over a period of time . value of money increases and purchasing power of the people falls. in the situation of hyper inflation . cost of production increases and equally decreases in business competitiveness.
business cycles
economic activity always shows ups and downs it never shows a stable pattern of change for all time to come. when economic activity goes down it is called recession when it reaches bottom it is called depression , when it starts rise it is called recovery , when it peaks up it is called boom.
budgetary deficit and fiscal policy
budgetary deficit refers to a situation when budget expenditures of the government are greater than the government receipts .budgetary deficit and the related fiscal policy . when balance of payments of our country is on deficit then government can borrow from different countries . through fiscal policy instruments government can complete deficit of our country like increases taxes, reduce government expenditure, increases deficit financing .
monetary policy
monetary measures by the government in terms of changing
interest rates
open market operations
cash reserve ratio
statuary liquidity ratio
through this instruments government can manage the money supply of the whole economy . when economy are in inflation government can control the money supply to increases the interest rates, purchase the government securities in the open market, increase the cash reserve ratio ,and increase the statuary liquidity ratio.
importance of macroeconomics
study of national income :- national income is the sum total of factor income(rent , wages ,interest , profits )earned by normal residents of the country during an accounting period.
NY = summation of factor income
2. study of business cycles :- economy faces from different phases like boom, recession , depression, recovery etc. these changes have an adverse effect on the economy. these changes depend on aggregate factors like aggregate saving, aggregate output , aggregate demand , aggregate supply .
3. change in the general price level :-different changes occur in the general price level. fall in the value of money or rise in price level is called inflation. fall in price le vel is called deflation.
4. helpful in the study of microeconomics :- economy as a whole can be divided into different economic units. to know the whole economy it is important to know the economic behavior of different units.
5.economic growth :- the problem of increasing the rate of economic development assumed great significance in underdeveloped countries . macroeconomics made it possible to know the factors accounting for economic growth.
limitations of macroeconomics
dependence on individual units :- macroeconomics are based on the sum total of individual units . it is necessary to know the individual units for knowing the whole economy like individual consumers , individual producers etc.
heterogeneous units :- these units are measured in different ways . it is not possible to express these units in uniform numbers or homogenous measure.
6 strawberry + 7 strawberry = 13 strawberry(it is meaningful aggregate)
6 strawberry + 7apples = 13 fruits (it is also a meaningful aggregate)
6 strawberry + 7 chairs = (it is a meaningless aggregate)
3. limited application :- another drawback of macroeconomics is that it is all related to theories . but they have very little use in practical life . it is very difficult to find out the various aggregates of macroeconomics.
4. it ignores the contribution of individual units :- in actual life, the economics activities and the decisions are taken by the individual units on private level and their effects on the whole economy.
5. different effects of aggregates :- another drawback of macroeconomics is that there is no equal effect on the different sectors. there is different effects of aggregates on the different sectors of the economy. for example rise in price level benefits the traders and industrialists and losses to producers to produce the product.
salient features of macroeconomics
study of the whole economy :- macroeconomics is the study of whole economics . it mainly deals with national income , aggregate consumption , aggregate investment, effective demand , price level, full employment, and less than full employment etc. macroeconomics proves that their theories and law it is not necessary to applicable in the whole economy.
macroeconomics :- macroeconomics is the study about inflation and deflation, full employment and under employment boom and depression. according to macroeconomics deficiency of effective demand causes deflation and its excess causes inflation. its deficiency causes unemployment and depression and its excess amounts for increase in employment and price level
short run nature of macroeconomics :- macroeconomics is a short run study. short run is that time period in which production cannot be increased by installing new plants and new machinery or not by changing the technique of production.
I) in short tie period , the quality and quantity of labour, the amount of capital, the existing technique, the extent of competition , broad social structure, etc.
4. role of national income ;- macroeconomics has given great importance to the study of national income. according to Keynes, without help of national income , problems of national output and employment cannot be solved.its study makes available to necessary data to consumption , saving , employment, investment etc.
5. role of consumption :- simply meaning of consumption it shows the consumption at different level of income. consumption is a function of income if level of income increases consumption also increases. there is direct relationship between income and consumption.
assumption of macroeconomics
macroeconomics theories are applicable in the short period only.
macroeconomics is based on the assumption of perfect competition. there is no external interferences in the determination of price .prices may automatically change with change in demand and supply.
macroeconomics is assumes labour is variable factor of production . because in short run labour cannot be changed.
it is assumed under macroeconomics , that in developed capitalist economy is a closed economy.it means there is no exports and imports in the economy.
another assumption of macroeconomics is that money is not only medium of exchange but also act as a store of value. it is not important that people spend all the income as soon as they get it.
under macroeconomics there is proper utilization of resources in the economy.
relation between microeconomics and macroeconomics
study of macroeconomics analysis is necessary for microeconomics analysis :- firstly microeconomics simple meaning is that it is a study of individual economic unit of an economy for example a consumer, a producer , etc. microeconomics analysis is based in the assumption of (other things being equal). the price fixed for commodity is not governed by its demand and supply alone but by the demand and supply of other goods as well.
study of microeconomics analysis is necessary for macroeconomics analysis :-study of macroeconomics calls for the study of microeconomics . like a society it is composed of individuals, similar an industry is composed of several firms producing homogenous products.
I) economy is a whole consists of the aggregate of several economic units . it is essential to know the economic behavior of different units
ii)collection of all firms composed industry and several industries form an economy
difference between microeconomics and macroeconomics
difference in the degree of aggregation
differences in objectives
different importance to price and income
differences in the methods of study
different assumptions
differences relating to change
analytical differences
