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CIRCULAR FLOW OF INCOME AND PRODUCT

The flow of production, income and expenditure is called as the circular flow.

Production gives rise to income, income gives rise to demand for goods and services
and demand in turn gives rise to expenditure. Expenditure leads to further production.

Thus the flow of production, income and expenditure becomes circular with no
beginning or no end. This flow is shown in the following diagram-

Diagram Showing Circular Flow of Income .

Production Income

Expenditure

Circular flow of income and product thus refers to the flow of money income or
the flow of goods and services across different sectors of the economy in a
circular form.

Money income or goods and services flow across different sectors because one sector
depends on the other sector. For example, households depend on the producers for the
supply of goods and services, and producers depend on the households for the factors
of production.

The interdependence between the different sectors of the economy helps us to

understand the level of macro economic variables in the economy, i.e. the level of
production, consumption, investment etc.Knowledge of macroeconomic variables
shows the level of economic activity in the economy. It indicates the level of growth
and development.

Concept of Money Flow and Real Flow –

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Real Flow Money Flow

1) Real flow of income implies the flow of
factor services as labour, capital, land and
entrepreneurship from the household
sector to the producing sector.
Households are the owners of factors of
production
2) There is a corresponding flow of goods
and services from the producing sector
to the household sector. Thus in
expression of real flow money does not
come into picture.
1) Money flow refers to the flow of factor
income, i.e. rent,interest,profit and wages
from the producing sector to the
household sector as monetary rewards
for their factor services (land, capital,
entrepreneurship and labour respectively)
2) The households spend their incomes
on the goods and services produced by
the producing sector. Accordingly, money
flows to the producing enterprises as
household expenditure.

Circular Flow Model showing Real Flows and Money Flows

The inner 2 arrows indicate the real flows and the outer 2 arrows reflect money flows.
There are 2 markets product market and the factor market

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The Circular Flow of Income in a Two Sector Economy

Assumptions –

 There are only 2 sectors in the economy i.e. firms and households
 Households supply factor services to firms and firms hire factor services from
households
 Household 7spend their entire income on consumption.
 Firms sell all that is produced to the household
 There is no government or foreign trade.

The economic interdependence between the household and firm are as follows

 The household sector supply factor services to the firms and firms sell that is
produced to the household. therefore whatever is produced by the firm is
consumed by the households.
 this type of flow – flow of factor services from the household to the firm and flow
of goods and services from firms to households is known as Real flow.
 Household receive their income in the form of wages, rent interest and profit for
providing factor services to firms. the household spend their income for the
purchase of goods and services from the firms.
 The consumption expenditure of the household will be equal to the money
received by the firm.
 Thus the payment made by the firm for the services of factors of production will
come back to the firm in the form of payment for goods and services. This flow of
income is called as money flow.

Two sector circular flow model offers following observations –

1) Total production of goods and services by the firms = Total consumption of

goods and services by the households

2) Factor payment by firms = Factor income of the household sector

3) Consumption expenditure of household sector = Income of household sector

4) Real flows of production and consumption of firms and households = Money

flows of income and expenditure of firms and households.

What does the Circular Flow Model show –

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1) Value of goods and services produce in the economy during a given period. This
is national product

2) Income generated in the economy in the form of rent, interest, profit and wages
during a given period of time. This is national income.

3) Value of goods and services (national product) is exactly equal to income

generated (national income)
Thus, national product = national income

4) All goods and services produced in the economy are ultimately purchased.
Thus, value of goods and services = expenditure on goods and services.

Why is the flow of Income and Product called the Circular Flow –

It is because of the following two reasons –

1) Corresponding to each real flow in one direction, there is a money/ income

flow from the other direction – Example: Corresponding to the flow of factor
services which is a real flow from the household to the producer sector, there is a
flow of factor payment which is a money flow from producer to the household
sector.
2) Receipts and payments of two sectors are of equal value – In case receipts are
less than the payments or payments are less than receipts, circularity is bound to
stop at one point or the other.

Important

All goods and services produced in the economy during an accounting year may not be sold during the year itself. Thus
the value of goods and services produced may be greater than the value of goods and services actually sold in the
market. Therefore the income generated in the economy is not entirely converted into expenditure. A part of the income
is not spent (or it is saved)

In such a situation how do we say Production = Income = Expenditure?

Here comes an important assumption. While estimating national product, we always treat unsold stock of the year as
purchase by of the producers themselves.

Accordingly total expenditure during the year becomes equal to the value of goods and services produced the year, and
also become equal to income generated during the year. Thus, Expenditure = Production = Income

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Concept of Leakages and Injections in the Circular Flow of Income

Injections
1) These are those flow variables which
cause an increase in the process of
production/ income generation in the
economy
2) These variables are: (i) Investment
(ii) Exports (iii) Consumption
Expenditure by the households or the
government.
Basically all these are expenditure
variables i.e. expenditure on the goods and
services produced in the economy.
3) These variables affect the economy in 2
ways: (i) Add to the production capacity
of the economy (ii) Generate demand for
the produced goods and services.
Accordingly, the growth process is speeded
up.
Leakages
1) These are the flow variables that have a
negative impact on the process of
production/ income generation in the
economy
2) These variables are: (i) Savings
(ii) Imports (income of foreign firms will
increase as people spend on imported
goods instead of on domestic goods)
(iii) Taxes by the government
3) All these variables reduce the flow of
income in the economy; hence they are
called withdrawals or leakages.

Two Sector Model with Savings / Financial System

Question) Explain macro economic equilibrium between households and business

sector with saving and investment (in a 2 sector model)

Households tend to save a part of their income. Emergence of savings implies the
emergence of a financial system. Financial system is the existence of a money market
(and capital market) in the economy along with various financial intermediaries such as
commercial banks, insurance companies; stock exchange etc.These financial
intermediaries serve as a link between savers and investors. Those who save park their
funds with the financial intermediaries and those who invest, borrow funds from the
financial intermediaries.
The activity of saving and borrowing for investment is reflected in the circular flow
model shown below
Diagram

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We assume that Saving (S) during the year is converted to Investment (I) during the year.

The above model gives the following information –

1) All income (Y) is not converted into consumption expenditure (C) but a part of it
is also saved (S). Therefore -
Y=C+S

2) Savings (S) is converted into investment (I) which is the expenditure by the
producers. Therefore –

S=I

3) If Y = C +S and S = I, we can conclude that:

Y=C+I

Y = C + S shows factor incomes generated during the year

Y = C + I shows expenditure on goods and services during the year.

Therefore we can say that:

Production = Income generated (in terms of C + S) = Expenditure (in terms of C+I)

Three Phases of Circular Flow

1) Production Phase -

It refers to the production of goods and services by the producer sector. It is the real flow
if considered in terms of quantum of goods and services produced. It is a money flow in
terms of the market value of goods produce.

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2) Distribution Phase -

It corresponds to the flow of income in terms of rent, interest, profit and wages from the
producer sector to the household sector. It is a money flow

3) Disposition Phase -

Disposition means expenditure. This phase refers to expenditure on the purchase of goods
and services by the households and the other sectors in the economy. This is money flow
from other sectors to the producer sector.

The phases of production, distribution and disposition form a circularity (circular flow) as
one phase is the consequence of the other phase.

Thus production generates income, income implies expenditure and expenditure leads to
further production.

Questions

1) What is meant by the circular flow of income and product

2) Define monetary flow
3) Define real flow
4) Name the factors of production and their remuneration
5) Who are the owners of factors of production
6) Why are money flows opposite to the real flows
7) What is financial system
8) What are injections into the circular flow
9) What are withdrawals from the circular flow
10) Draw a 2 sector circular flow model without a financial system
11) Distinguish between money flows and real flows
12) What are the 3 phases of circular flow of income and product
13) How are producers and households dependent on each other in a circular flow
model
14) State 2 basic principles of circular flow of income and product

(i) Real flows in terms of goods and services are the opposite of money flow,
thereby causing a circular flow
(ii) Flow of income across different sectors always implies the identity between
payments and receipts.

15) Explain why is saving treated as a leakage in a circular flow model

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A withdrawal / leakage consist of any part of income generated in producing the

national output which is not passed on within the system. Saving constitutes such a
withdrawal. Saving refers to that part of the income which is not spent. They have a
negative impact on the process of production/ income generation in the economy

16) In the context of circular flow models, when is income = consumption

Or
Why should the aggregate final expenditure (consumption) of an economy be
equal to the aggregate factor payments (income)? Explain

In a simple 2 sector model economy without government sector, external sector and
without any financial system, the aggregate final expenditure of an economy would
be equal to the aggregate factor payments. In other words income will be equal to
consumption.

In this simplified economy, there is only one way in which the households may dispose
off their earnings i.e. by spending their entire income on goods and services
produced by the domestic firms. The other channels of disposing off their income are
closed.

We have assumed that households do not save since money market or capital market
does not exist, they do not pay taxes to the government since there is no government
sector and they do not buy imported goods since there is no external sector.

In other words, factors of production use their remuneration to buy the goods and
services which they helped in producing.

The aggregate consumption by the households in the economy = aggregate

expenditure on goods and services produced by he firms in the economy

The entire income of the economy therefore comes back to the producers in the form of
sales revenue. There is no leakage from the system.

There is no difference between the amounts that the firms had distributed in the form of
factor payments/ income and the aggregate consumption expenditure that they receive as
sales revenue.