UNIT IV

Circular Flow of Income

1. In every economy three activities never stop:
(1) Production of goods and services
(2) Generation of income in the term of rent, wage, profit, interest
(3) Expenditure in term of consumption expenditure and investment
expenditure.
2. In fact, these activities are the lifeline of an economy.
3. The concept of economy does not exist without these activities.
4. It is difficult to trace the beginning and end of these activities.
5. Production, income and expenditure are flow variable.
Circle flow means:
A) It refers to the unending flow of activities of production, income and
expenditure involving different sectors of the economy. In fact
production, income and expenditure are the three phases of a circular
flow in the economy.
B) Each activity is cause and consequence of the other activity for example
production of the producing sector generates income of household
sector. Similarly, expenditure by the households generates demand for
further production.
C) Accordingly, production, income generation and expenditure keep
chasing each other like three dots continuously moving in a circle.

The Curve shows:

1) Production of goods and services cause generation of income which leads to
expenditure in the economy
2) Expenditure causes more demand in the economy which leads to more
production.
3) Consequently, there is generation of income and expenditure.
4) The flow of production, income and expenditure form a circular flow with no
beginning or an end.
Sectors of an economy
1) Household sector
2) Producer sector
 3) Government sector
4) Rest of the world sector.
2 SECTOR ECONOMY:
In 2 sector economy, there are only 2 sectors exist which perform economic
activities namely household and producer sector. Household supply factor services
to producer sector and household spend their entire income on consumption.
Producer sells what is produced to households.
Household sector:
Receipt of household:
1. Factor payments from the producer sector such as rent for land, wages for
labour, interest for capital and profit for entrepreneurship.
2. Goods and services from the producer sector.
Payment of the household:
1. Household provides factor services such as land, labour, capital and
entrepreneurship to producer sector.
2. Consumption expenditure on the purchase of goods and services.
Producer sector:
Receipt of producer:
1. Producer received factor services such as land, labour, capital and
entrepreneurship from household services.
2. Consumption expenditure of the household becomes income of the producer
sector.
Payment of the producer:
1. Producer sector gives factor payment to the household such as rent for land,
wages for labour, interest for capital and profit for entrepreneurship.
2. Producer sector provides goods and services to household sector.
Assumptions of 2 sector economy:
1. There are only sector working in the economy.
2. There is no saving by the household
3. There is no Investment
4. There is no government control.
5. There is close economy mean; there is no export and import.
Diagram:
2 SECTOR ECONOMY WITH FINANCE SECTOR:
In a 2 sector economy, there are 2 sectors namely, household, producer. Assumption of
2 sectors with finance model:
There are 2 sectors working in an economy.
Household does not spend their entire income on the purchase of goods and
services.
There is no government control.
There is close economy means there is no export and import in the economy.
Explanations:
Household sector:
Receipts of the household:
Factor income from the producer sector
Borrows from financial sector.
Payments:
Household sector makes payment to the producing sector as
consumption expenditure.
Household deposit their saving with financial sector.
Producer sector:
Receipts of the producer sector:
Producer sector receives income from household sector on account
of its sale of goods and services.
They take borrowing from financial sector.
Payments of the producer sector:
Producer sector makes factor payments to the household sector
for using the factor services.
Saving of the producer sector goes to the financial sector
Financial/ capital sector:
Receipts of the capital sector:
Household sector makes deposit of their saving with financial sector.
Producer sector makes deposit of their saving with
financial sector Payments of the financial sector:
Financial sector gives loan to household for consumption purpose.
Financial sector gives loan to producer sector for investment purpose
3 SECTOR ECONOMY WITH FINANCE/ CAPITAL SECTOR:
In a three sector economy, there are 3 sectors namely, household, producer and
government sector. Assumption of 3 sector model:
There are 3 sectors working in an economy.
Household does not spend their entire income on the purchase of goods and
services.
There is government control.
There is close economy means there is no export and import in the economy.
Explanations:
Household sector:
Receipts of the household:
Factor income from the producer sector
Transfer income from the government sector.
Borrows from financial sector.
Payments:
Household sector makes payment to the producing sector as
consumption expenditure.
The household sector makes tax payments to the government sector
Household deposit their saving with financial sector.
Producer sector:
Receipts of the producer sector:
Producer sector receives income from household sector and
government sector on account of its sale of goods and services.
They take borrowing from financial sector.
They take financial help from government sector in the form
of subsidies. Payments of the producer sector:
Producer sector makes factor payments to the household sector
for using the factor services.
Taxes are paid to the government sector.
Saving of the producer sector goes to the financial sector.
Government sector:
Receipt of the government sector:
 Government sector receive direct taxes from the household sector.
Government sector receive indirect taxes from the producer sector.
Government sector takes borrowings from financial sector.
Payments of the government sector:
The government sector makes transfer payment to the household
sector.
The government sector gives subsidies to the producer sector.
The saving of the government sector goes to financial sector.
Financial/ capital sector:
Receipts of the capital sector:
Household sector makes deposit of their saving with financial sector.
Producer sector makes deposit of their saving with financial sector.
Government sector makes deposit of their saving with financial
sector.
Payments of the financial sector:
Financial sector gives loan to household for consumption purpose.
Financial sector gives loan to producer sector for investment
purpose.
Financial sector gives loan to government for consumption as well
as investment purpose.

4 SECTOR ECONOMY WITH FINANCIAL SECTOR:

In a 4 sector economy, there are 4 sectors namely, household, producer, government
and rest of the world sector are involve.
Assumption of 4 sector modal:
a. There are 4 sectors working in an economy.
b. Household does not spend their entire income on the purchase of goods and
services.
c. There is government control.
d. There is open economy means; there is export and import in the economy.
e. Household deposits their saving with finance sector and producer sector
take loan from financial sector for investment purpose. i.e. saving of the
household = investment of the producer sector.
Household sector:
Receipts of the household:
Factor income from the producer sector
 Transfer income from the government sector.
Borrows from financial sector.
Current transfer from rest of the world.
Payments:
Household sector makes payment to the producing sector
as consumption expenditure.
The household sector makes tax payments to the government
sector
Household deposit their saving with financial sector.
Current transfer to rest of the world.
Producer sector:
Receipts of the producer sector:
Producer sector receives income from household sector and
government sector on account of its sale of goods and services.
They take borrowing from financial sector.
They take financial help from government sector in the form of
subsidies.
Export receipt from rest of the world.

Payments of the producer sector:

Producer sector makes factor payments to the household
sector for using the factor services.
Taxes are paid to the government sector.
Saving of the producer sector goes to the financial sector.
Import payments to rest of the world.
Government sector:
Receipt of the government sector:
Government sector receive direct taxes from the household
sector.
Government sector receive indirect taxes from the producer
sector.
Government sector takes borrowings from financial
sector.
Payments of the government sector:
The government sector makes transfer payment to the household
sector.
The government sector gives subsidies to the producer sector.
The saving of the government sector goes to financial sector.
Financial/ capital sector:
Receipts of the capital sector:
Household sector makes deposit of their saving with financial
sector.
 Producer sector makes deposit of their saving with financial
sector.
Government sector makes deposit of their saving with financial
sector.
Payments of the financial sector:
Financial sector gives loan to household for consumption
purpose.
Financial sector gives loan to producer sector for investment
purpose.
Financial sector gives loan to government for consumption as
well as investment purpose.

Leakage in circular flow model

These are those variables which have negative impact on the process of production
in the economy. All these variables reduce the flow of income in the economy. These
are:
1) Saving
2) Import
3) Taxes by the government.
Leakage in 2 sector economy..No Leakage
2 with finance sector Saving
3 with finance sector Saving and tax
4 with finance sector saving, tax and import.
Injections in the circular flow model
These are those variables which cause an expansion in the process of production
in the economy. Basically these are expenditure variables- expenditure on the
goods and services producing in the economy. These are:
1) Investment
2) Export
3) Consumption expenditure.
injection in 2 sector economy..No injection
injection in 2 with finance sector investment
3 with finance sector investment and subsidies
4 with finance sector investment, subsidies and export