Circular Flow of Income and Expenditure

 1- Meaning of Circular Flow

An economy consists of various economic agents like producers, buyers, sellers, consumers etc. These people involve in different economic activities such as production, buying, selling, exchange, consumption of goods and service etc. These activities generate an income for a group of people and an make expenditure for another group. Further the income of the group of people turns into expenditure which again constitutes the income of the other group of people. There is such a process, whereby the national income and expenditure of an economy, flows in a circular manner. Such a flow of income and expenditure is said to be circular flow of income and expenditure.

2- Types of Flow

There are mainly two types of flow as mentioned below.

1- Real Flow

2- Money Flow

2.1- Real Flow

A real flow is the flow of goods and services. The real flow has been shown diagrammatically. In the figure below, the direction of arrows shows the taking and giving agents. The green-grocer is taking flour from the miller. It has been shown by the pointing arrow towards green-grocer. The green-grocer is also giving some fruits to the miller in return for taking flour. The  figure shows that the goods have been exchanged mutually. Such a mutual exchange of goods and services is a real flow.

2.2- Money Flow

Instead of goods, when goods are exchanged with money, the flow will be money flow. For example, as shown in the figure below, the green-grocer pays money for flour to the miller and the miller also pays money for fruits to the green-grocer. This shows that the money transaction has taken place in which money flows from one economic agent to another. Such a flow is the money flow.

3-Circular flow of income and expenditure in a two sector economy

The two sector economy is that in which there are only household and business sectors actively involved in the economy. There is no government interfere and no links with the outside world in this type of economy. In fact, a two sector economy is not found in a real world because no economy can function, in a real sense, without the role of government and linkage with the rest of the world. However, to begin with, a two sector economy provides a convenient starting point to analyze the circular flows. Before we proceed to analyze circular flow of income and expenditure, let's look at the main features and functions of the household and business sectors.

Assumptions:

a- There are only household and business sectors in the economy.

b- There is no government.

c- The HS owns factors of production and generates income by selling them to BS.

d- The BS produces goods and services and sell them to HS.

e- The entire income of HS & BS is spent and there is no saving.

3.1-Household Sector:

Receipts:- The household sector owns all sorts of factors of production, such as land, labor, capital and entrepreneurship. This sector receives income in the form of wages, rent, interest and profits by selling the services of these factors of production to the business sector.

Payments:- The household sector, on the other hand, is also a group of consumers that consumes all goods and services produced by the business sector. Therefore, they spend their income received by selling the factor services on the goods and services produced by business sector.

3.2- Business Sector:

Receipts:- The goods and services that are produced in business sector are sold to the household sector and the business sector receives revenue from the household sector. This receipt is ultimately spent on hiring factor services and again flows back to the household sector

Payments:- The business sector consists of producers who produce goods and services by hiring factors such as land, labor and capital from the household sector. It makes expenditure on factor services which goes to household sector. This expenditure of business sector ultimately inflows back from the sale of final goods to household sector. In this manner, the income (Y) of one sector flows in the form of expenditure (E) to another sector and vice versa.

Now, let's describe and illustrate the circular flow of income and expenditure in a diagrammatic form. The circular flow of income and expenditure has been shown in the following figure, where the product market is shown in the upper portion and the factor market is shown in the lower portion. In the product market, the household sector purchases goods and services from the business sector. In the factor market, the household sector receives income from the business sector for providing the factor services to it. Thus, the household sector purchases goods and services provided by business sector and in return, it makes payments to the business sector in the form of 'consumption expenditure'.

Similarly, the business sector makes payments to the household sector in the form of 'factor payments' for the factor services rendered by the household sector to the business sector. Thus, the payments go round in a circular manner from the business sector to the household sector and from the household sector to the business sector as shown by the arrows in the outer portion of the figure. There are also flows of goods and services in the opposite direction to the flows of money payments. Factor services flow from household sector to the business sector in the factor market and goods flow from business sector to the household sector in the product market as shown in the inner portion of the figure. These two flows bring the equality between gross national product and gross national income.

4-Circular flow of income and expenditure in a two sector economy with Saving and Investment (S=I)

The circular flow of income and expenditure is not as explained above. The entire income of HS is not spent on consumption of goods and services. A part of it is saved for future purpose. It is a leakage or outflow from the stream of circular flow which causes a fall in income, expenditure and in national income. The BS also may save a part of its revenue for depreciation and other purposes. It is also a leakage from circular flow. These savings are deposited in banks or other financial institutions in financial market and the financial market provides investment funds to BS for further investment. When the funds move to BS from capital market, it is an injection or inflow in the stream of income and expenditure. These inflows bring about an increase in income, expenditure and in national income.

The following figure shows the relationship between household and business sectors. It shows how the incomes of household & business sectors outflow in the form saving and how it inflows in the form of investment in the economy.

5- Circular Flow of Income and Expenditure in Three Sector or Closed Economy

The three sector economy (model) is formed by adding the government sector to the two sector economy. The three sector economy is somewhat realistic economy as it includes the govt. which plays a vital role in the economy. The govt. carries out some fiscal operations which affect the economy in different ways. Mainly our analysis includes three of the fiscal operations such as taxes, govt. expenditure, and transfer payments.

The three sector closed economy is based on the following assumptions.

1. There is the inclusion of govt. sector.

2. There is no foreign link, the economy is closed.

3. The govt. adopts the fiscal operations like taxation, govt expenditure and transfer payments.

 

Let’s analyze the relations of HS and BS with Govt. sectors.

a- Household and Govt. Sectors:- Govt. imposes direct and taxes on HS which causes a fall in consumption and saving of HS. So the tax is a leakage from the stream of circular flow. But it provides transfer payments and factor service payments to HS which is an injection in the circular flow of income and expenditure.

b- Business and Govt. Sectors:- The BS sector also has to pay direct and indirect taxes to Govt. it is a leakage from the circular flow which adversely affects the production. On the other hand govt. provides subsidies to BS and also makes payments to BS for the purchase of capital goods. This is an injection into the circular flow of income and expenditure.

c- Household, Business and Govt. Sectors:- As already noted taxation is a leakage which reduces consumption and saving of HS. Reduction in consumption, in turn, reduces the sales and income of BS. Tax on BS reduces their investment & production. The govt. compensates leakages by making purchases from BS and buying services from HS equal the amount of taxes. So the total sales equal to production of firm. In this way the circular flow of income and expenditure remains in equilibrium.

The graphic presentation of circular flow of income and expenditure in three sectors economy is as follows.

 

The above figure shows that the direct & indirect taxes from household and business sectors are leakages whereas wages, salaries & transfer payments to household sector as well as govt purchases and subsidies to business sector are inflows in the economy. If all these outflows & inflows are equal (S+T=I+G), the economy remains in equilibrium otherwise there is disequilibrium in the economy which causes fall in income, output, employment and national income.

Govt. imposes direct and taxes on HS which causes a fall in consumption and saving of HS. So the tax is a leakage from the stream of circular flow. But it provides transfer payments and factor service payments to HS which is an injection in the circular flow of income and expenditure.

6- The Circular Flow of Income and Expenditure in Four Sector Economy or Open Economy

The four sector economy is formed by adding foreign sector to the three sector economy. It consists of HS, BS, Govt sector and foreign sector. The foreign sector transacts with the household, business and government sectors through imports and exports of goods and services as well as borrowing and lending operations. The imports and lending are leakages or outflows from the circular flow of income. Contrary to it, the exports and borrowings are the inflows or injections into the circular flow of income.

The foreign transactions make a complex economic system; for the sake of simplicity we make the assumptions.

1. The foreign sector consists of exports, imports borrowing and lending operations.

2. The household sector exports only factor or labor services.

3. The business sector makes imports and exports of only goods and non-labor services .

4. The government also takes part in imports and exports of goods and services as well as borrowing from and lending to international countries and agencies.

Now, let's consider the inflows or injections and outflows or leakages of household, business, and government sectors in relation to the foreign sector.

a. Household Sector:- The household sector supplies factor services and manpower to the foreign countries and in return the household sector receives foreign payments and remittances. These receipts of household sector are the inflows or injections into the circular flow of income and expenditure. HS purchases the goods imported by business sector and the payments made to business sector by households go to foreign countries. These payments are the leakages or outflows from the income stream.

b. Business Sector:- The business sector makes exports domestically produced goods to the foreign sector and receives payments in return for it. These receipts acquired by the business sector are inflows or injections into the circular flow of income and expenditure. On the contrary to it, the business sector imports consumer goods for internal selling and also imports capital goods like machinery, equipment, raw materials etc. from the foreign sector. In return for these imports, it makes payments to the foreign countries which are leakages or outflows from the circular flows.

c. Government Sector:- The government sector also makes transactions of goods and services with the foreign sector. It exports goods and services and also receives interest, dividends, etc. for its investments in foreign sector. Moreover, it receives aids and borrowings from the foreign countries and international agencies to fulfill the deficit budgeting. All these receipts from the foreign sector are inflows or injections into the circular flow. On the other hand, the government imports goods and services from the foreign sector and makes payments for them. It also provides royalties, interests, dividends, profits etc. for the foreign investments in the country. All these payments made by the government are leakages or outflows from the circular flow.

d. Foreign Sector:- The foreign sector imports goods and services from the business sector of our domestic economy. It also imports manpower, factor services etc. from the household sector. In return for all these services, it makes payments to our domestic economy. Moreover, it lends fund to the government on demand and also provides, interest, dividends, profits for investments of business and government sectors. All these payments of foreign sector are the receipts or inflows for our domestic economy. On the other hand, it exports consumer and capital goods to the business and government sectors. It also borrows funds from the domestic government. It constitutes outflows from the domestic economy. 

The foreign sector imports goods and services from the business sector of our domestic economy. It also imports manpower, factor services etc. from the household sector. In return for all these services, it makes payments to our domestic economy. Moreover, it lends fund to the government on demand and also provides, interest, dividends, profits for investments of business and government sectors. All these payments of foreign sector are the receipts or inflows for our domestic economy. On the other hand, it exports consumer and capital goods to the business and government sectors. It also borrows funds from the domestic government. It constitutes outflows from the domestic economy. In this way, the income flows in a circular manner from the domestic economy to foreign sector and vice versa. When all the outflows or leakages are equal to all inflows or injections, the economy is in equilibrium and a trade balance position. When all the outflows are greater than all those inflows, the economy downfalls and it is in the position of a deficit trading. On the contrary to it, when the outflows are smaller than all those inflows, the economy uplifts and it is in a state of surplus trading.

Four-Sector

In the above figure, it has been shown how the domestic economy interacts with rest of world and how inflows and outflows affect the economy in different ways.

7- The Overall Effect of Leakages and Injections on the Economy

From the study of two, three and four sector economies, as previously described, savings (S), taxes (T) and imports (M) are the leakages or withdrawals from the circular flow of income. Conversely, investments (I), government expenditure (G), and exports (X) are the injections into the circular flow of income in economy. These leakages and injections affect the circular flow of income in the following three ways.

1. A balanced effect

When the amount of all kinds of leakages is equal to the sum of injections in the circular flow of income, the economy is in a balanced position or it is in an equilibrium situation. There is neither a deficiency nor an increase in aggregate demand in relation to the aggregate supply of goods and services and vice-versa in the economy. Therefore, in a balanced effect, the equilibrium situation of the circular flow of income remains undisturbed. Symbolically, a balanced effect is expressed as, (S+T+M) = (I+G+X).

2. An expansion effect

All kinds of leakages do not always equal to the sum of injections. The amount of leakages may be either greater or smaller than the amount of injections in the circular flow of income. When the amount of leakages is less than the sum of injections, it brings about an expansionary effect on the circular flow of income with an increase in income, output, employment and aggregate demand. This situation in the economy expands all economic activities. Symbolically, an expansionary effect is shown as,(S+T+M) < (I+G+X).

3. A contraction effect

When the sum of all of the leakages is more than the amount of all of the injections, it causes a contraction effect on the circular flow of income with a fall in income, output, employment, and aggregate demand. In fact, this situation in the economy contracts all economic activities resulting recession in the economy. Symbolically, a contraction effect can be expressed as, (S+T+M) > (I+G+X).

Either there is an expansionary or a contraction effect on the circular flow of income, the government can control these effects through its monetary, fiscal and foreign trade policies. At the time of increasing leakages, it can neutralize imports and increase in exports, cut down tax rates, increase in government spending and promote private investment. On the contrary to it, with an increase in the amount of injections, the government can adopt the measures to increase in saving, imposes high taxes, decrease in its spending and import goods and services. By adopting these measures, the government regulates the economy and maintains the equilibrium condition in the circular flow of income or in the economy.