Circular Flow of Money

Vinaikrishnan Nair

ME-Circular flow of money-XMBA36

Simple Funda !!

Mr. Sanjay Dutt has a lot of

money…..he decides to gift his wife a
car. A Rolls Royce worth Rs. 3 Crores.

Waste of money ????? …

Actually economics doesn’t believe

so….
Sanjay Dutt’s expense of Rs. 3 Crores is
an income for the Car Dealer

ONE MAN’S EXPENSE IS ANOTHER MAN’S INCOME

ME-Circular flow of money-XMBA36

 The Economist’s View

Economic models on income & expenditure are extremely complex in

reality.
To understand the flows in a simplified manner, the economy is divided in
to four sectors:
1. Household Sector
2. Business Sector or the Firm
3. Government Sector
4. Foreign Sector

In the following slides we will see the following economic models:

1. 2-sector model including the household and business sector
2. 3-sector model including, business and govt sectors
3. 4-sector model including the household, business, govt & foreign
sector

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 Two Sector Model

Households provide to firms:

• Labour
• Land
• Capital
• Entrepreneurship
In return, they receive “factor income”
wages, rent, dividend & profits

This represents the “Factor Market”

Firms provide goods & services which

are consumed by households.

This represents the “Commodity

Market”

•Household are assumed to own all Factors of production, all their income are returns on FOP,
they spend their income on all goods and services.
• Firms in turn are assumed to own no resources and use resources to produce. No savings.
• Model represents a Pvt. closed economy
• Obviously unrealistic since we need to ignore money flows generated by government &
foreign sectors.

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 Two Sector Model.. [Key identities]

Y = FP

FP = w+r+i+p
w+r+i+p = V = M

V=Y=M

Where Y=household income, FP=factor payments, w = wages, r = rent, i= interest, p= profits, V

= value of output, and M = Money flows (at constant prices)

In the final analysis, household income = factor payments = the money value of output

That is Y = FP = V
This is important for national income of determination

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 Two Sector Model – (Savings & Capital Market)

• Households may set

aside money as savings
for their future needs.
• These funds are
invested and flow to the
Capital firms.
Mkt
• Hence the concept of
“Capital Market”

• The model assumes that the finances are directly supplied by

household to firms

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Three Sector Model

Government Sector adds to 2

fiscal transactions.
1) Taxation (direct and
indirect taxes) which is
contributed by household
& firm both.
2) Government expenditure
on goods and services,
subsidies etc.

Taxes are withdrawals from

income flow

Expenditure adds to the

aggregate demand.

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Four Sector Model

The Fourth sector highlights

the key role that the foreign
sector plays in the economy.

It expands the circular flow

model by illustrating how
exports add to, and imports
subtract from, the domestic
flow of production and
income.

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 Four Sector Model..continued

The foreign sector consists of 2 kinds of international transactions:

1) Foreign Trade (Exports and Imports of goods and services).
2) Inflow and outflow of capital.

To make it simple. The following assumptions are made.

1) The external sector consists of only exports and imports of goods and
services.
2) The export and import of goods and non-labour services are made
only by the firms.
3) The households export only labour.

Exports (X) make goods and services flow out of country and make
money flow into the country.
Similarly, Imports (M) make inflow of goods and services and flow of
money out of the country.

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 Four Sector Model.. continued

Also export of manpower by households generate income by bring

foreign remittances.

The effect of foreign trade depends on trade balance,

which equals X – M.

If X > M means inflow of foreign income is greater than the outflow.

If X < M means outflow is greater than the inflow.

If X = M means inflow and outflow are equal.

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Thank You

ME-Circular flow of money-XMBA36