Unit 2 Circular flow of Income (2).docx

Unit 2 Circular flow of Income 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 flow...

Unit 2 Circular flow of Income 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 flow; product or real flow (flow of goods and services) and Money flow. Product and money flow in opposite directions in a circular fashion. The product-flow consists of - Factor flow , that is flow of factor services - Goods flow, that is flow of goods and services In a monetized economy, the flow of factors of production generates money flow in the form of factor payments which take the form of factor income flows. Factor incomes are spent on consumer and capital goods, which take form of expenditure flow. Expenditure flow is in the form of money flow. Both product and expenditure flow in a circular fashion in opposite directions. The entire economic system can therefore be viewed as circular flows of factor incomes and expenditure. The magnitude of these flows, in fact, determines the size of national income. The Circular Flow of Income shows how different units in an economy interact, how household consumption is a firm's income, which pays for labour and other factors of production, and who provides households with income. It may be noted at the outset that the mechanism of income and expenditure flow is extremely complex in reality. The economist, however, use simplified models to illustrate the circular flows of income and expenditure. To present the flows of income and expenditure, the economy is divided into four sectors; - Household sector - Business / Firm sector - Government sector - Foreign sector These four sectors are combined to make the following three models for the purpose of illustrating the circular flow of income and expenditure, and of product and money I. Two-sector model including the household and business sector II. Three-sector model including the household, business and government sector III. Four-sector model including the household, business, government and the foreign sectors. **[The Two-sector model (Closed Economy)]** The two-sector model consists of only household and firm sectors. This model represents a private closed economy in which product and money flows generated by the government and the foreign sectors are ignored. A two-sector model is obviously unrealistic model. However, to begin with a two-sector economy provides a convenient starting point to analyse the circular flows. Before we analyse the circular flows, let us look at the basic features and functions of the households and the firms **Households:** The households are assumed to possess certain specific features Households consist of people living under one roof with a source of income. They are the owners of factors of production which they sell to firms to earn income. Their income is used to buy goods and services. This is known as consumption expenditure (C). **Business Firms**: the business firms, on the other hand are assumed to have the following features and functions; firms own no resources of their own, they hire the factors of production (land labour and capital) from the households, they use factors of produce and sell goods and services to the households and they do not save, that is there is no corporate saving. Their expenditure on capital goods (production equipment, new buildings and inventories) is known as investment expenditure (I). ***[Assumptions ]*** - Households spend their total income on consumer and capital goods produced by the firms. They do not hoard any part of their income. - Firms produce goods and services only as much as demanded by the households. They do not maintain any inventory. - 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 outside source C:\\Users\\a.adeyanju\\Desktop\\pic008.gifFigure 1 We can see this circular flow in Figure 1. Households sell their factor services to firms (in the factor markets) and in exchange receive wages (the left hand side of the flow). In the meantime, households spend this income on goods and services (in the goods market) and in exchange receive the goods and service themselves (the right hand side of the flow). Economists call the wages plus the other forms of income, national income and give it the code \'Y\'. **[Withdrawals, Injections and the Size of income flows]** The magnitude of income and expenditure flow is determined by the size of the society\`s income and expenditure: the larger the size of income (or expenditure), the larger the size of flows and vice versa. In reality, however there are leakages from and additions to the circular flow of income and expenditure. The leakages and additions are also called withdrawals and injections, respectively. In the two sector model, a withdrawal is 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. For example, if households set aside a part of their income as a provision for old age or as a provision against the loss of job, and so on and do not spend it unless required, it is a withdrawal. It is of important to note that savings is a withdrawal. But when savings are ultimately spent in form of investment they take the form of injections. The withdrawals are comparable to the concept of hoarding. Similarly, 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 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 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 into the economy by spending their past savings or by borrowing from the outside of the model economy. Injection increases the size of the flow. ***[Summary Note:]*** ***Leakage: A leakage is any income not passed on in the circular flow.*** On the other hand, some firms make and sell exports overseas, and others borrow money and invest it in their firms in the form of capital goods. These are coded **\'X\' for exports and \'I\' for investment** and are called injections as the money returns into the circular flows. ***Injection: An injection is any expenditure not originating in the household sector, including investment, government spending and exports*** **[The Two-sector economy (Open Economy)]** Figure 2 The diagram above illustrates a two-sector model, open economy. The flow will be balanced and therefore in equilibrium when the injections are equal to the leakages. If the leakages are greater than the injections then national income will fall, while if injections are greater than leakages national income will rise. This starts to show us some possible policies to promote growth - policies that help boost exports or investment will lead to more injections into the circular flow and therefore boost national income. We called the economy illustrated in Figure 2 an open economy because it is open to trade with the outside world. If it did not trade outside of itself, we would call it a two-sector, closed economy. **[Three-sector Model: A model with Government Household and Business]** The three sector model is formed by adding the government sector to the two-sector model. A three-sector model depicts a more realistic economy as it includes the government which plays an important role in the economy. The inclusion of the government into the model requires adding and analysing the effects of government\`s fiscal operations - taxation and expenditure. We have included - Taxation (direct and indirect) - Government expenditure on goods and services, subsidies and transfer payments These fiscal transactions have different kinds of effect s on the income and expenditure flows. Taxes are withdrawals from income flows because they reduce private disposable income and therefore, consumption, expenditure and savings. The government expenditure adds to the aggregate demand is an injection into the income stream. The government expenditure adds to the aggregate demand in form of government purchases of factor services from the households and goods and services from the business sector. The transfer payments by the government are injections to the circular flows. They add to the household income in which leads to increase in household demand for consumer goods. The diagram below shows the three --sector model including the government sector. C:\\Users\\a.adeyanju\\Desktop\\three sector model.jpgFigure 3 **[Circular flows in a Four-sector model: a model with the foreign sector]** In this section, we describe the circular flows of income and expenditure in four-sector model. The four-sector model is formed by adding foreign sector to the three-sector model. The foreign sector consists of the kinds of international transaction - Foreign trade that is exports and import of goods and services - Inflow and outflow of capital From the view point of circular flow of income, each sector has dual roles to play in the economy; while a sector receives certain payments from other sectors, it pays back to those sectors as well. Circular flow of income in different sectors can be expressed as follows: [Household Sector] Receipts: The household sector receives factor income in the form of rent, wages, interest, and profit from the business sector. It also receives transfer payments from the government sector. Payments: The income of the household sector flows into the business sector, government sector and capital markets in the form of consumption expenditure, taxes and savings respectively. [Business Sector] Receipts: The principle receipts of the business sector constitute of income from the sale of goods and services, income from exports, subsidies from government sector, and borrowings from the capital market. Payments: Factor payments, import payments, and savings constitute the principle payments from business sector to the household sector, government sector, foreign sector and the capital market. [Government Sector] Receipts: The major source of income for the government sector includes the taxes paid by household and business sector. Besides this, it also receives interests and dividends for the investments made. Payments: The government sectors make payments to different sectors in the form of transfer payments, subsidies, grants, etc. It pays to the business sector in return for the goods purchased; makes transfer payments like pension funds, scholarships, etc. to the household sector. If the government receipts are greater than the expenses, the surplus goes to capital market. In case of cash deficit, the government borrows from the capital market to maintain a balance in the economy. [Foreign Sector] Receipts: The foreign sector receives income from the business sector in return for the goods and services imported by the latter. Payments: Foreign sectors need to make payment to the business sector from where imports have been made. If exports exceed imports, the economy has surplus balance of payment. In case exports exceed imports, the economy faces a deficit balance of payment. Depending on the trade policies, the economy tries to maintain a balance between imports and exports. [Capital Market] Household, business, and government sectors deposit their excess of income to the capital markets as savings. These savings are borrowed by the business sector or government sector for making investments in different projects. **Reference** Dwivedi DN. (2011). Macroeconomic Theory and Policy. 3rd Ed. Tata McGraw-Hill Publishers Mankiw, N. Gregory. (2011). Essentials of Economics. 6th Ed. Pearson Publishers Mankiw, N. Gregory. (2009). Principles of Macroeconomics. South-Western Cengage Learning, Mason OH. Retrieved from: [[https://www.businesstopia.net/economics/macro/circular-flow-income-and-expenditure-four-sector-economy]](https://www.businesstopia.net/economics/macro/circular-flow-income-and-expenditure-four-sector-economy)