Circular flow of income

The circular flow of income is an economic model which depicts how the money flows in the economy. The circular flow of income shows the major exchanges in the economy of the money, goods, services etc. The neoclassical model of economy shows how the exchanges take place. It forms the basis of the National Income accountancy and the Macroeconomics. In real the flows are much more complicated, but this flow illustrates the flows in a major way i.e. considering only a few sectors in the economy. The economists have depicted the ides of the flows in an expanded manner so as to reduce the complexity.

The circular flow of economy illustrates the interdependence of the economies on each other. This flow works on the basis that one sector’s goods or services are consumed by the other sector and in return it pays to the sector. Thus, there is an opposite and equal flow.

To study the circular flow of income, various models have been developed varying on the number of sectors involved. The following are the models that are taken up to understand the topic with more clarity:

  1. Two sector model: Firms and Households
  2. Three sector model: Firms, Households and Government
  3. Four sector model: Firms, Households, Government and Financial Institutions
  4. Five sector model: Firms, Households, Government, Financial Institutions and Rest of the world

Let’s take a deep look at each of the sector to understand it better:

  1. Firms: The function of the firms is to produce the goods and services using the factors of production. It supplies the final goods and services to the households and to the other sectors as well.
  2. Households: The households serve the basic function of providing the firms with the factors of production like Capital, Labor, and Land. It is the household sector that provides with the factor of production and takes the pay for the factors employed. It also purchases the output from the firms and pays in return.
  3. Government: Government is involved in the economy for the function of taxation and spending for the welfare of the economy.
  4. Rest of the world: The rest of the world converts the closed economy into an open economy. Rest of the world transactions consist of the Imports and Exports in the economy.
  5. Financial Institutions: The financial institutions are involved in the borrowing and lending of the money to the firms or the households. The financial institutions include the banking and the non-banking institutions.

Models:

1. Two sector model: The two sector model consists of just two sectors in the economy i.e. Firms and Households. The households provide the firms with the factors of production to produce goods and services and get paid for the services provided. They use this money to buy goods and services from the firm. Thus, there is an equal and opposite exchange in the economy, thus maintaining the balance of flows.

In two sector model;
Y=E=O;
Where,
Y- Income
E- Expenditure
O- Output

The basic assumptions for the working of two sector model are:

  • (i) There are only two sectors in the economy i.e. Households and Firms.
  • (ii) All the output is sold by the firms to the households. The households spend all of their Income (Y) and there is no Saving (S).
  • (iii) There is no Government.
  • (iv) There is no Financial Sector.
  • (v) There is no foreign sector
Two sector model

2. Three Sector Model: The three sector model consists of the firm, households and the government. In three sector model, the dealings between the firm and the households remain the same as in the two sector model. The government induces the functioning of the flows in the economy. The government receives the money inflows through taxing imposed on the Households income as well as the firms. This income to the government flows to the firms and the households in the form of payment for purchasing the goods and services and in the form of transfer payments or subsidies.

Three sector model

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3. Four Sector Model: The four sector model consists of the firms, households, government and the rest of the world. The process of dealings remains the same with the households, government and the firms. The Rest of the World transactions consist of the Imports and Exports made within the economy which gives a rise to the flow of money. The same has been illustrated in the image:1

4. Five Sector Model: The five sector model comes up with another addition to the economy i.e. the financial sector. The financial sector consists of both banking as well as non-banking institutions. It encourages the investments and savings within the economy. It has been shown in image: 1.

Four and five Sector Model

There is an important aspect that affects the working of the multiplier i.e. Leakages and Injections.

1. Leakages: Leakages means the leakage or the withdrawal from the flow. It reduces the amount that is flowing in the economy. Usually there is no leakage or injection in the two sector model. It starts with the introduction of the other sectors in the economy. The examples of Leakages could be: Taxes, Saving, Imports etc. All these reduce the flow of the money in the economy.

2. Injection: Injection refers to the injecting or adding or introduction of income to the flow which increases the flow in the economy. The example of injections could be: Investments, Government spending, Exports etc.

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