theory of circular flow of income

                         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

1. 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 .

2. income phase :- in this phase factor of production get income in the form of rent , wages, interest , dividends and profits

3. 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

1. real flow

2. 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

1. two sector model :- on the assumption that there are only sectors in the economy I)household sector  ii)producing sector.

2. 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 .

3. 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

1. 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

2. 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

• saving

•  net taxes

• imports

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

1. 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

1. mutual relation

2.  triple identity of production , income and expenditure

3. estimate of national income