Circular flow of Activity

• An economy can be defined as an integrated

system of production, exchange, and
consumption. In carrying out these economic
activities, people are involved in making
transactions—they buy and sell goods and
services.
• Economic transactions generate two kinds of
flows: (i) product or goods flow, i.e., the flow
of goods and services, and (ii) money flow.
Product and money flow in opposite directions
in a circular pattern. The product and money
continue to flow incessantly. This is how the
economy works.
• In a monetised economy, the flow begins with the flow of
factors of production.
• The flow of factors of production generates money flows in
the form of factor payments.
• Factor payments take the form of factor income flows.
• Factor incomes are spent on consumer and capital goods,
which take the form of expenditure flow.
• Expenditure flow is in the form of money flow. Both product
and expenditure flow in a circular pattern in opposite
directions. The entire economic system can therefore be
viewed as circular flow of factor incomes and expenditure.
• The magnitude of these flows determines the size of
national income. It may be noted at the outset that the flow
mechanism of goods and money is extremely complex in
reality.
• To present the flows of goods and money, the
economy is divided into four sectors:
• (i) household sector, (ii) business sector or the
firms, (iii) government sector, (iv) foreign
sector.
• These four sectors are combined in different
models to make the following three models
for the purpose of illustrating the circular
flows of income and expenditure, and of
product and money.
• Two-sector model including the household
and business sectors.
• Three-sector model including the household,
business and the government sectors
• Four-sector model including the household,
business, the government and the foreign
sectors.
• CIRCULAR FLOWS IN THE TWO SECTOR MODEL
• The two-sector model is a model of a simplified economy. It is
assumed to consist of only two economic sectors, viz., households
and firms. The two-sector model is obviously an unrealistic model.
• Households
• The households are assumed to possess certain specific
features:
• (i) households are the owners of all the factors of
production—labour, land, capital and entrepreneurship,
• (ii) their total income consists of returns on their factors
of production—wages, rent, interest, and profits,
• (iii) they are the consumer of all the consumer goods
and services; and
• (iv) they spend their total income on goods and services
produced by the firms—if they save any part of their income,
it flows to the firms in the form of investment.
• Households are, in fact, the main determinants of the volume
of circular flows of products and money.

• Business Firms
• The business firms, on the other hand, are assumed to have the
following features and functions:
• (i) firms do not own resources of their own,
• (ii) they hire the factors of production—land, labour and
capital—from the households,
• (iii) they use the factors of production and produce and sell
goods and services to the households; and
• (iv) they do not save, that is, there is no corporate saving.
• Assumptions
• The households spend their total income on
consumer and capital goods produced by the firms.
They do not hoard any part of their income.
• The firms produce goods and services only as much
as demanded by the households. They do not
maintain any inventory.
• The firms make factor payments to the households
as rent, wages, interest, and profits.
• There is no inflow or outflow of income or of goods
and services from any external source.
• In reality, however, there are leakages from and additions to
the circular flows of income and expenditure. The leakages
and additions are also called withdrawals and injections,
respectively.
• In the two-sector model, a withdrawal means the amount
that is set aside by the households and firms and is not spent
on the domestically produced goods and services over a
period of time.
• It is important to note that saving is a withdrawal.
• But when savings are ultimately spent in the form of
investment, they take the form of injections. The withdrawals
are comparable to the concept of hoarding.
• Similarly, the firms may also withhold a part of their total
receipts and may not return it to the circular flows in the form
of factor payments, say, in anticipation of depression. Such
withdrawals reduce the size of the circular flow.
• On the other hand, an injection is the amount spent by the
households and firms in addition to their regular incomes and
receipts.
• An injection by the households is the expenditure that they make in
addition to what they receive from the firms as current factor
incomes.
• The injections by the households may be in the form of spending
inherited savings, own hoardings, or by borrowing and spending
on consumer goods.
• And, an injection by the firms is the expenditure which they make
in addition to what they receive from the sale of goods and
services. Firms can inject money into the economy by spending
their past savings or by borrowing from the outside of the model
economy.
• Injections increase the size of the flow.
• The lower half of the figure shows the withdrawals and injections
by the households and the upper half shows the withdrawals and
• Two-Sector Model with Capital Market
• We have hitherto assumed that the households supply finances
directly to the firms. In reality, however, household savings
flow to the banks and from banks to the firms. In order to
explain the role of savings on the circular flows, we assume that
all savings are made by the households and extend the two-
sector model by including the financial sector.
• The financial sector (known also as financial market and capital
market) is constituted of a large variety of institutions involved
in collecting household savings and passing them on to the
business sector.
• In our simplified two-sector model, however, the financial
sector includes only the banks and financial intermediaries
(FIs), like insurance companies, industrial finance
corporations, which accept deposits from the households and
invest them in the business sector in the form of loans and
advances.
• A new sector, labelled as ‘Capital Market’ has been added. The
dashed arrow, labelled S, shows the flow of household savings
to the capital market, i.e., to the banks and financial
intermediaries (FIs) in the form of deposits. The banks and FIs
use the deposits to buy shares and debentures of the firms
which is investment (I).
• The investment flow is shown by the dashed arrow labelled I.
With the inclusion of the financial sector as the capital market,
the households incomes (Y) is divided into two parts: (i)
consumption expenditure (C), and (ii) savings (S).
• C and S take different routes to reach the business sector. The
consumption expenditure (C) flows directly to the firms,
whereas savings (S) are routed through the financial sector.
Note that the savings (S) take ultimately the form of
investment (I).
• In the final analysis, we find that the entire money income
generated by the firms flows back to the firms and it flows
• CIRCULAR FLOWS IN THREE-SECTOR MODEL: A MODEL WITH
GOVERNMENT INCOME AND EXPENDITURE
• A three-sector model depicts a more realistic economy as it
includes the government which plays an important economic role
in the economy.
• the government’s fiscal operations—taxation and expenditure.
• Taxation reduces private disposable income and, therefore,
consumption expenditure and savings.
• On the other hand, the government expenditure is an injection
into the income stream. They add to the household income
which leads to an increase in household demand for consumer
goods.
• The government expenditure adds to the aggregate demand in
the form of government purchases of factor services from the
households and goods and services from the business sector.
• Is the government tax revenue (T) always equal
to the government expenditure(G)?
• In Fig., total tax revenue is assumed to be equal
to the total government spending. In reality,
however, the two variables may not be necessarily
equal. It depends on the government budgetary
policy. If the
• government adopts a balanced budget policy,
then G = TR.
• If the government adopts a deficit budget policy,
then G Epx)> TR.
• And, if the government follows surplus budget
policy, then G < TR.
• CIRCULAR FLOWS IN FOUR-SECTOR MODEL: A MODEL
WITH THE FOREIGN SECTOR
• a four-sector model—the final and the realistic model.
• The foreign sector consists of two kinds of international
transactions: (i) foreign trade, that is, export and import
of goods and services, and (ii) inflow and outflow of
capital, i.e., international investment. The international
transactions take place through a complex system.
• For simplicity sake, however, we make the following
assumptions:
• The external sector consists of only export and import of
goods and services. The export and import of goods and
non-labour services are made only by the firms.
• The households export only labour.
• Exports (X) make goods and services flow out of
the country and make money (foreign exchange)
flow into the country in the form ‘receipts from
export.’ This is, in fact, flow of foreign incomes
into the economy.
• Exports (X) represent injections into the
economy.
• Similarly, imports (M) make inflow of goods and
services from abroad and flow of money (foreign
exchange) out of the country. This is the flow of
expenditure out of the economy.
• Imports (M) represent withdrawals from the
circular flows.
• trade balance, which equals X– M.
• Recall that X represents injections and M represents
withdrawals.
• If X > M, it means that inflow of foreign income is
greater than the outflow of income. It implies that there
is a net injection into the economy arising from foreign
trade.
• The net gain from foreign trade increases the magnitude
of circular flows of income and expenditure.
• By the same logic, if X < M, there is net withdrawal
from the economy and it decreases the magnitude of
circular flows.
• And, if X = M, inflow and outflow of incomes are equal.
• This leaves the circular flows unaffected.