Circular Flow of Income and Expenditure9 min read


Circular Flow of Income and Expenditure

The circular flow of income and expenditure clearly presents the flow of resources and payments among the sectors of the economy. It clearly depicts the leakages and injection in any economy.

Two sector economy

Two sector economy is an economy which includes household sector (HHs) and Business sector (BS) as the main agent. In a two-sector economy, the equilibrium is the situation in which there is no tendency for level of income, expenditure, and output to change. The circular flow of income and expenditure in the two-sector economy shows the interaction of the household sector and the business sector.

Assumptions

  • Household sector consumes goods and services
  • The Business sector provides goods and services
  • There is no time lag between income and expenditure
  • All the incomes are spend
  • The business sector produces that much goods and services as demanded by the consumer.

Household sector

  • The household sector is the owner of all resources
  • HHs consumes goods and services
  • Assists in the business sector to produce goods and services.
  • Not involved in the production of goods and services.

Business sector

  • Investment
  • The business sector produces goods and services
  • Hires resources from HHS.
  • Selling goods and services in the product market from the factor market.

Circular Flow of Income and Expenditure in two sector economy

In the diagram, two rectangular boxes include two primary agents, that is, the household sector (HHs) and Business Sector (BS). The clockwise circular flow shows the real flow as it envelops the flow of resources and flow of goods and services from HHs to BS and vice-versa respectively. Similarly, anticlockwise flow shows the money flow as it envelops the flow of payment of resources and payment of goods and services from BS to HHs and vice-versa respectively.

Moreover, the flow of resources (N, L, K, E) from HHs to BS and the flow of payment on the return of resources from BS to HHs evinces factor market. Similarly, the flow of goods and services from BS to HHs and flow of price as a return to goods and services from HHs to BS evinces Product Market.

Therefore, a simple two-sector circular flow diagram clearly presents four markets. The clockwise circular flow is the real market, while the anticlockwise circular flow is the money market. Likewise, the upper half of the rectangle represents the factor market, and the lower half of the rectangle represents the product market.

The two-sector economy with Saving and Investment

Circular Flow of Income and Expenditure

In the diagram, the rectangular boxes show primary agents of the two-sector economy and the oval shapes shows saving and investment along with the involvement of the financial market. Saving refers to the hoarding of current asset or liquidity for future benefit. As the presence of saving is felt, the ratio of income to consumption is greater than one, which indicates that BS is compelled to pile up goods and services as inventory and weaken the economy as it reduces national income.

So, the business sector, clear and ingenious, takes a loan from the financial market, where HHs deposits saving and invest for a production process in resources. The investment creates job opportunities and hence increases consumption, Aggregate demand increases, which urges producers to increase aggregate supply and hence NI increases and reaches to the previous state. Thus, the circular flow is maintained with balance. Hence, saving acts as leakage reduces National Income and causes economic shrinkage. Likewise, Investment acts as an injection and increases National Income.

Three sector economy

Three sector economy is developed by eminent British Economist, John Maynard Keynes. The three sector economy consists of the household sector, business sector, and active involvement of regulating body, government sector, which is responsible for the uplift of a crumbling economy. The circular flow if Income and expenditure have many significances, as it shows interdependency between HHs and BS and GSS vividly.

It vividly presents GS as regulating body and is an economic agent that helps in an uplift of crumbling economy through autonomous investment and consumption. Moreover, it concerns where and how the taxation or tax amount is raised. The circular flow of income and expenditure in the three-sector economy shows the interaction of the household sector, the business sector, and the government sector.

Assumptions

  • Household sector consumes goods and services
  • The Business sector provides goods and services
  • There is no time lag between income and expenditure
  • All the incomes are spend
  • The business sector produces that much goods and services as demanded by the consumer
  • Government acts as the regulating body
  • The imposition of taxation on both consumer and producer
  • Autonomous consumption and investment

Household sector

  • The household sector is the owner of all resources
  • HHs consumes goods and services
  • Assists in the business sector to produce goods and services.
  • Not involved in the production of goods and services.

Business sector

  • Investment
  • The business sector produces goods and services
  • Hires resources from HHs.
  • Selling goods and services in the product market from the factor market.

Government Sector

  • Regulating body
  • Consumption and investment

Circular Flow of Income and Expenditure

In the diagram, rectangular figures show primary agents of economy, that is, the household sector (HHs), Business sector (BS), and Government Sector (GS). The oval figures show the role of saving and investment in any economy. The clockwise flow of resources and goods and services between HHS and BS shows the real flow. Similarly, the anticlockwise flow of payment, price of resources and price of goods and services evinces money flow.

Moreover, saving weakens the economy as it creates disturbances in the smooth flow of resources. HHS deposits saving in a financial market to earn interest and the financial market provides loan to BS to earn interest and BS takes the loan for investment. Hence, the disturbance created by saving is settled down through investment (taken as a loan).

Government sector plays a vital role in the economy as regulating body and is responsible for the collection of tax (direct and indirect). HHs is the owner of all resources (N, L, K, O) and GS hires resources from HHs and pays for the inputs as Interest, wages, Rent, and Profit. The payment by GS to HHs is free of tax, that is direct tax is deducted from the payment before it reaches to HHS or it is taxed at source.

So, HHs only obtains disposable income. Likewise, GS consumes goods and services produced by BS and makes a payment for it. The business sector pays tax raised from the household sector and business sector is used in the development of infrastructures and used as assistance during economic shrinkage through consumption and investment.

Hence, GS acts as a regulating body as it provides assistance during economic shrinkage or downturn.

Four Sector Economy

Fours sector economy is the consequence of the introduction of import and export or foreign economy. In the three sector economy. The three sector economy indicates a closed economy due to the absence of foreign sector whereas the four-sector economy evinces an open economy. The increasing growing interdependency between nations of the world has instigated the evolution of four sector economy.

The presentation of active involvement of foreign sector and the indispensable link between household sector (HHs), Business sector (BS), and the government sector (GS) with the foreign sector (FS) have been clearly presented through the circular flow of income and expenditure. The circular flow of income and expenditure in the four-sector economy shows the interaction of the household sector, the business sector, the government sector, and the foreign sector.

Assumptions

  • Household sector consumes goods and services
  • The Business sector provides goods and services
  • There is no time lag between income and expenditure
  • All the incomes are spend
  • The business sector produces that much goods and services as demanded by the consumer
  • Government acts as the regulating body
  • The imposition of taxation on both consumer and producer
  • Autonomous consumption and investment
  • Import depends upon the domestic country’s income and price
  • Export depends upon a foreign country’s income, so it is exogenously determined.

Household sector

  • The household sector is the owner of all resources
  • HHs consumes goods and services
  • Assists in the business sector to produce goods and services.
  • Not involved in the production of goods and services.

Business sector

  • Investment
  • The business sector produces goods and services
  • Hires resources from HHS.
  • Selling goods and services in the product market from the factor market.

Government Sector

  • Regulating body
  • Consumption and investment

Foreign Sector

  • Deals with import and export of goods and services
  • Import depends upon the domestic country’s income and price
  • Export depends upon a foreign country’s income and policy

Circular Flow of Income and Expenditure

In the diagram, the interconnection between economic agents of open economy namely: Household sector (HHs), Business Sector (BS), Government Sector (GS), and Foreign sector (FS) has been presented vividly, which c can be considered as one of the significances of the circular flow of income and expenditure.

The inter-dependency between HHs, BS, and GS which is presented by the flow of resources from HHs to BS and GS and payment from them, flow of goods and services from BS to HHs, and GS and the payment from them and the flow of taxation from HHs (if payment is done along with tax) and BS, resembles with that of three sector economy. While considering only HHs, BS and GS, there is no difference between the three sector economy and open economy.

The concept of the four sector economy has close adherence to the foreign sector. The circular flow diagram has made it possible to vividly evince the inter-dependency among HHs, BS, and GS with FS. Since HHs is an owner of all resources, FS hires resources and pays remittances in return. The circular flow of income and expenditure has vividly presented the complex relationship between BS and FS in terms of import and export. FS consumes goods and services from BS, that is, export and receives a payment that is, earning from export.

Similar, BS imports raw materials or resources and does the payment to import. Thus, the flow of import and export along with their respective payment has been clearly presented. In addition, GS and FS have a close association. Financial aid, which acts as two-way traffic has created an indispensable link with them. Moreover, GS charges customs duties, royalty’s and the like from FS while importing and exporting of goods and services and resources.

Thus, to make a vivid presentation showing the interdependency among HHs, BS, GS, and FS seem to be quite unattainable without the application of circular flow of income and expenditure.

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Other online resources

Circular flow of Income | Wikipedia

Circular Flow of Income and Expenditure9 min read
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