Circular flow of income

In this simplified image, the relationship between the decision-makers in the circular flow model is shown. Larger arrows show primary factors, whilst the red smaller arrows show subsequent or secondary factors.

In economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers.^[1][2] In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income^[1]. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households. More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports.

Human wants are unlimited and are of recurring nature therefore, production process remains a continuous and demanding process. In this process, household sector provides various factors of production such as land, labour, capital and enterprise to producers who produce by goods and services by co-ordinating them. Producers or business sector in return makes payments in the form of rent, wages, interest and profits to the household sector. Again household sector spends this income to fulfil its wants in the form of consumption expenditure. Business sector supplies them goods and services produced and gets income in return of it. Thus expenditure of one sector becomes the income of the other and supply of goods and services by one section of the community becomes demand for the other. This process is unending and forms the circular flow of income, expenditure and production. Reference- S.Dinesh Introduction to Macro Economics.

A continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning nor an end. The circular flow of income involves two basic principles:- 1.In any exchange process, the seller or producer receives the same amount what buyer or consumer spends. 2.Goods and services flow in one direction and money payment to get these flow in return direction, causes a circular flow.

Circular flows are classified as: Real Flow and Money Flow. Real Flow- In a simple economy, the flow of factor services from households to firms and corresponding flow of goods and services from firms to households s known to be as real flow.

Assume a simple two sector economy- household and firm sectors, in which the households provides factor services to firms, which in return provides goods and services to them as a reward. Since there will be an exchange of goods and services between the two sectors in physical form without involving money, therefore, it is known as real flow.

Money Flow- In a modern two sector economy, money acts as a medium of exchange between goods and factor services. Money flow of income refers to a monetary payment from firms to households for their factor services and in return monetary payments from households to firms against their goods and services. Household sector gets monetary reward for their services in the form of rent, wages, interest, and profit form firm sector and spends it for obtaining various types of goods to satisfy their wants. Money acts as a helping agent in such an exchange.

Assumptions

The basic circular flow of income model consists of seven assumptions:

1. The economy consists of two sectors: households and firms.
2. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).
3. All output (O) produced by firms is purchased by households through their expenditure (E).
4. There is no financial sector.
5. There is no government sector.
6. There is no overseas sector.
7. It is a closed economy with no exports or imports.

Two Sector Model

In the simple two sector circular flow of income model the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is:

Y = E = O

This means that the expenditure of buyers (households) becomes income for sellers (firms). The firms then spend this income on factors of production such as labour, capital and raw materials, "transferring" their income to the factor owners. The factor owners spend this income on goods which leads to a circular flow of income.

Three Sector Model

It includes household sector, producing sector and government sector. It will study a circular flow income in these sectors excluding rest of the world i.e closed economy income. Here flows from household sector and producing sector to government sector are in the form of taxes. The income received from the government sector flows to producing and household sector in the form of payments for government purchases of goods and services as well as payment of subsides and transfer payments. Every payement has a receipt in response of it by which aggregate expenditure of an economy becomes identical to aggregate income and makes this circular flow and unending.

Four Sector Model

A modern monetary economy comprises of a network of four sector economy these are-

     1.Household sector
     2.Firms or Producing sector
     3.Government sector
     4.Rest of the world sector.

Each of the above sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. Money facilitates such an exchange smoothly. A residual of each market comes in capital market as saving which inturn is invested in firms and government sector. Technically speaking, so long as lending is equal to the borrowing i.e leakage is equal to injections, the circular flow will continue indefinitely. However this job is done by financial institutions in the economy. Reference- S. Dinesh Introduction to Macro Economics .

Five sector model

Table 1 All leakages and injections in five sector model

LEAKAGES	INJECTION
Saving (S)	Investment (I)
Taxes (T)	Government Spending (G)
Imports (M)	Exports (X)

Circular flow of income diagram

The five sector model of the circular flow of income is a more realistic representation of the economy. Unlike the two sector model where there are six assumptions the five sector circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three more sectors introduced. The first is the Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing (savings from households) and lending of money. In terms of the circular flow of income model the leakage that financial institutions provide in the economy is the option for households to save their money. This is a leakage because the saved money can not be spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector. An example of a group in the finance sector includes banks such as Westpac or financial institutions such as Suncorp.

The next sector introduced into the circular flow of income is the Government Sector that consists of the economic activities of local, state and federal governments. The leakage that the Government sector provides is through the collection of revenue through Taxes (T) that is provided by households and firms to the government. For this reason they are a leakage because it is a leakage out of the current income thus reducing the expenditure on current goods and services. The injection provided by the government sector is Government spending (G) that provides collective services and welfare payments to the community. An example of a tax collected by the government as a leakage is income tax and an injection into the economy can be when the government redistributes this income in the form of welfare payments, that is a form of government spending back into the economy.

The final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to an open economy. The main leakage from this sector are imports (M), which represent spending by residents into the rest of the world. The main injection provided by this sector is the exports of goods and services which generate income for the exporters from overseas residents. An example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter of the wool (the farmer) therefore more money enters the economy thus making it an injection. Another example is China processing the wool into items such as coats and Australia importing the product by paying the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.

In terms of the five sector circular flow of income model the state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy. This can be shown as:

Savings + Taxes + Imports = Investment + Government Spending + Exports

OR

S + T + M = I + G + X.

This can be further illustrated through the fictitious economy of Noka where:

S + T + M = I + G + X
$100 + $150 + $50 = $50 + $100 + $150
$300 = $300

Therefore since the leakages are equal to the injections the economy is in a stable state of equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of equilibrium the sum of total leakages does not equal the sum of total injections. By giving values to the leakages and injections the circular flow of income can be used to show the state of disequilibrium. Disequilibrium can be shown as:

S + T + M ≠ I + G + X

Therefore it can be shown as one of the below equations where:

Total leakages > Total injections

$150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + 150 (X)

Or

Total Leakages < Total injections

$50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + 150 (X)

The effects of disequilibrium vary according to which of the above equations they belong to.

If S + T + M > I + G + X the levels of income, output, expenditure and employment will fall causing a recession or contraction in the overall economic activity. But if S + T + M < I + G + X the levels of income, output, expenditure and employment will rise causing a boom or expansion in economic activity.

To manage this problem, if disequilibrium were to occur in the five sector circular flow of income model, changes in expenditure and output will lead to equilibrium being regained. An example of this is if:

S + T + M > I + G + X the levels of income, expenditure and output will fall causing a contraction or recession in the overall economic activity. As the income falls (Figure 4) households will cut down on all leakages such as saving, they will also pay less in taxation and with a lower income they will spend less on imports. This will lead to a fall in the leakages until they equal the injections and a lower level of equilibrium will be the result.

The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the levels of income, expenditure and output will greatly rise causing a boom in economic activity. As the households income increases there will be a higher opportunity to save therefore saving in the financial sector will increase, taxation for the higher threshold will increase and they will be able to spend more on imports. In this case when the leakages increase they will continue to rise until they are equal to the level injections. The end result of this disequilibrium situation will be a higher level of equilibrium.

Significance of Study of Circular Flow of Income

    1.Measurement  of National Income- National income is an estimation of aggregation of any of economic activity of the circular flow. It is either the income of all the factors of production or the expenditure of various sectors of economy. However, aggregate amount of each of the activity is identical to each other.
    2.Knowledge of Interdependence- Circular  flow of income signifies the interdependence of each of activity upon one another. If there is no consumption, there will be no demand and expenditure which inturn restricts the amount of production and income.
    3.Unending Nature of Economic Activities- It signifies that production, income and expenditure are of unending nature, therefore, economic activities in an economy can never come to a halt. National income is also bound to rise in future.
    4.Injections and Leakages Reference- A General Approach to Macroeconomic Policy

Difference between Real Flow and Money Flow

    1.Real flow is the exchange of goods and services between household and firms whereas money flow is the monetary exchange between two sectors.
    2.In real flow household sector supplies raw material, land, labour, capital and enterprise to firms and in return firms sector provides finished goods and services to household sector. Whereas in money flow, firm sector gives remuneration in the form of money to household sector a wages and salaries, rent, interest etc.
    3.Difficulties of barter system for the exchange of goods and factor services between households and firms sector in real flow, whereas no such difficulty or inconvenience arise in money flow.
    4- when goods and services flow from one sector of the economy to another. it is known as real flow.

Phases or Stages of Circular Flow of Income

Production, consumption expenditure and generation of income are the three basic economic activities of an economy that go on endlessly and are titled as circular flow of income. Production gives rise to income, income gives rise to demand for goods and services ; such a demand gives rise to expenditure and expenditure induces for further production. The whole process forms the basis for circular flow of income and related activities- production, income and expenditure are known as phases or stages of circular flow of income.

'Production → Income → Expenditure → Production.'

     1.Production Phase- Production means creation of utility to satisfy human wants. It involves the co-ordination of all the factors of production in some desired ratio. This job is performed by a producer or firm who takes an initiative with the motive of earning profits. He hires land, labour, capital and an organization and makes them payment in the form of rent, wages and salaries and interest. This phase is to produce goods and services and after selling them, it generates income.
     
    2.Income Phase- Producing firms earn revenue from the sale of goods and services produced by them. Whole of the earning is divided between factors provided by household sector in the form of ret, wages, interest and profits. Such an income is classified into three parts:-
     •  Compensation of employees- Wages, salaries, commission, bonus etc.
     •  Operating Surplus- Profits, rent, interest, royalty etc.
     •  Mixed Income- Income of self- employed

Thus production takes the shape of income of household sector.

   3.Expenditure Phase- Household sector spends its income to satisfy unlimited and recurring human wants. Any saving out of total income takes the shape of investment on capital goods that helps in generating the income of the economy. Expenditure becomes the income of producing sector that promotes further the uninterrupted flow of income.

Reference- S. Dinesh Introduction to Macro economics.

References

1. ^ ^{a b} Sloman, John. (1999), page 12
2. ^ Mankiw, Gregory. (2006), page 23

Further reading

1. Sloman, John (1999). Economics, 3rd edition. Prentice Economics. Europe: Prentice-Hall. ISBN 0273655744. 
2. Mankiw, Gregory (2006). Principles of Economics. Thomson Europe. ISBN 1844801330. 

See also

• History of economic thought
• Barter economy
• Demand economy
• Free-market economy
• Market