Three circular flow of income in the economy
the three circular flow of income in the economy
What is circular flow of income?
The circular flow of income refers to the process in which the countries national income and expenditure of the economy flows in a circular way steadily through the time period. The various components of the countries national income and expenditure, this include following;
1. Savings
2. Investment
3. Taxation
4. Government expenditure
5. Exports
6. Import etc.
All this will be discussed as you read through this research such that current and cross current n presented in such a manner that national income flow equals the national expenditure.
3 major circular flow of income in an economy
1. Circular flow of income in a two sector economy:
The circular flow of income in a two sector economy shows that there only two major sector, which is the household and the business. The household sector owns all the factors of production, that is, land, labor and capital. This economic sector collects money by selling the services of these factors of production to the business sector. The business sector consists of the producers who are into the production of various products and sell them to the household sector or the major consumers. That is the household sector purchase the output of products of the business sector. The circular flow of income and expenditure in the economy in such an economy can be explain as first in the products market , the household sector buys goods and services from the business sector while in the factor market the household sector receives money from the former for the availability of services rendered. That is the household sector buys all the goods and services provided by the business sector and make payments to the latter in line of these. The business sector, in the other way round, make the payments to the household for the services that was given by the latter to the business wage payments for labor services, profit and all the capital that was supplied. These payments go around in a circular flow and manner from the business sector to the household sector and from the household sector to the business sector. These are also circular flow of goods and services in the opposite direction to the money payment flows. Goods flow from the business sector to the household sector in the product market, and services flow from the household sector to the business sector in the factor market, this two income flow gives gross net product equals gross net investment(GNP=GNI).
Circular flow of income with savings and investment added
In the actual economy it is not as explain above, in an economy the inflow and leakages occurs in the expenditure and income flow. And such leakages are savings, and inflow or injections are investment which are equal each other. This shows the circular flow of expenditure and income which is altered by the inclusion of savings and investment. The expenditure has two alternatives ways from household and the product market.
1. Directly via consumption expenditure
2. Indirectly via investment expenditure.
Here there is a capital market in between savings and investment flows from households to business firms. The capital market refers to a number of financial institutions such commercial banks, saving banks, loan financial institutions, bond and stock markets. The capital market controls the investment and saving activities carried out in the household and the business firm. The households supplies savings to the capital market and the firms, in turn obtains investment funds from the capital market.
2. Circular flow of income in a three-sector closed economy:
So far we have been working on the circular flow of a two sector model of an economy. To this we add the government sector so as to make it a three sector closed model of circular flow of income and expenditure. For this reason, we add taxation and government expenditures in our presentation. Taxation is a leakage for the circular low and government expenditures are injections into the circular flow of income.
First, take the circular flow between the household sector and the government sector. Taxes in the form of personal income tax and commodity taxes paid by the household sector are outflows or leakages from the circular flow. But the government buys the services of the households makes transfer payment in the form of old age pensions, unemployment relief, sickness benefits etc. and also spends on them to provides certain social services like education, health, housing, water, parks, and other important facilities. All such expenditure by the government authority is injections into the circular flow of income.
Next take the circular flow between the business sector and the government sector. All the types of taxes that is paid by business sector to the government agencies are leakages from the circular flow. On the other hand, the government buys all its required goods of all types from the business sector, gives subsidies and makes transfer payment to firms in order to encourage their production. This government expenditure is injections into the circular flow. Now we take the household, business and government sector together to show their inflow and outflows in the circular flow of income. As already noted, taxation is a leakages from the circular flow to reduce consumption and savings of the household sector. Reduced consumption, in turn, reduces the sales and income of the firms. On the other hand, taxes on the business firm tend to reduce their investment and production.
The government offsets these leakages by making sales from business sector and buying services of the household sector equal production of firms. In this ways, the circular flow of income and expenditure remain in equilibrium. In this sector the taxes flow out of the household and business sector and go to the government. Now the government makes investment and for this purchase goods and services are an injection in the circular flow of income and taxes are leakages.
If government purchase exceeds the net taxes then the government will incur a deficit equal to the difference between the two. Therefore the government expenditure and taxes, the government funds its deficit budget gy borrowing from the capital market which receives finance from the household in the form of savings. On the other hand, if the net taxes exceed government purchase the government will have a budget surplus. In this situation the government authority will reduce public debt and supplies finance to the capital market which is received by firms.
3. Adding foreign sector: circular flow in a four sector open economy:
So far the circular flow of income and expenditure has been shown in the case of a closed economy. But the actual economy is an open one where foreign trade plays an important role. Export is an injection or inflows into the economy. They create incomes for the domestic firm. When foreigners buy goods and services produced by domestic firm, they are exports in the circular flow of income. On the other hand, imports are leakages from the circular flow. They are expenditure incurred by the household sector to purchase goods from foreign nations.
Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. The household sector buys goods imported from other countries and makes payments for them which are a leakage from the circular. The households may receive transfer payments from the foreign sector for the services rendered by them in foreign nations.
On the other, the business sector exports goods to foreign nations and its receipts are an injection in the circular flow. Similarly, there are many services rendered by business firms to foreign nations. On the other hand, the business sector makes payments to the foreign sector for imports of capital goods, machinery, raw material, consumer goods, and services from other countries. These are the leakages from the circular flow.
Like the business sector, modern government also export and import goods and services, and lend to and borrow from other countries who are rich. For all export goods the government receives payment from outside the countries. Similarly, the government receives payment from foreigners when they visit the country as tourist and also for educational purposes etc. and also when the government provides shipping, insurance and banking services to foreigners through the state owned institutions. It also collect royalties, interest, dividends etc. for investment made for the buying of goods and services to foreigners.
This sector will show the circular flow of the four sector open economy with saving, taxes and imports shown as leakages from the circular flow of income, and investment, government purchases and exports as injection into the circular flow. Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors which are:
1. The household
2. The business and
3. The government.
These outflows and inflows pass through the foreign sector which is also called the “balance of payments sector”. If export exceeds imports, it has a deficit in the balance of payments. But in the long run, export of an economy must balance its imports to have a balance of payments situation. This is achieved by the foreign trade policies that are implemented by the economy.
The whole analysis can simply be described in a equation as:
Y = C + I + G
Where Y represents the production of goods and services,
Where C stands for consumption expenditure,
Where I stands for investment level in the economy and
Where G stands for government expenditure respectively
Now we are going to be introducing taxation into the model and equation to equate the government expenditure:
Therefore, Y = C + S + G where S is savings T is taxation now by equating (1) and (2),we will then get C + I + G = C + S + T further more I + G = S + T with the introduction of the foreign sector, we will then divide investment into domestic investment and foreign investment.
10 importance of the circular flow of income in the economy
The concept of the circular flow of income gives a clear cut picture of the economy. We can know whether the economy is working efficiently or whether there is any problem hindering the smooth functioning of the economy and for helping the government in formulating policy measures. The importances of the circular flow are presented below:
1. Study of the problem of disequilibrium. It is with the help of circular flow that the problems of disequilibrium and the restoration of equilibrium can be studied.
2. Effects of leakages and inflows. The role of leakages enables us to study their effects on the national economy. For example, imports are a leakage out of the circular flow of income because they are payments made to a foreign country. To stop this leakages government should adopt correct measures so as to increase exports and decrease imports.
3. Link between producers and consumers. The circular flow establishes a link between producers and consumer. It is through income that producer buy the services of the factor of production with which the latter, in turn purchase goods from the producers.
4. Creates a network of market. As a corollary to the above point, the linking of producers and consumers through the circular flow of income and expenditure has created a network of markets for different goods and services where problems relating to their sale and purchase are automatically solved.
5. Inflationary and deflationary tendencies. Leakages or injections in the circular flow disturb the smooth functioning of the economy. For example, savings is a leakage out of the expenditure stream. If savings increases, this depresses the circular flow of income. This tends to reduce employment, income and prices, thereby leading to a deflationary process in the economy. On the other hand, consumption tends to increase employment, income, output and prices that lead to inflationary tendencies.
6. Basis of the multiplier. Again, if leakages exceed injections in the circular flow, the total income, output, and prices over time. On the other hand, if injections into the circular flow exceed leakages, the income is increased in the economy. This leads to a cumulative rise in employment, income, output, prices over a period of time. In fact, the basis of the Keynesian multiplier is the cumulative movements in the circular flow of income.
7. Importance of monetary policy. The study of circular flow also highlights the importance of monetary policy to bring about the equality of savings and investment in the economy. The credit market itself is controlled by the government through monetary policy. When savings exceeds investment or investment exceed savings, money and credit policies help to stimulate or retard investment spending. This is how a fall or rise in prices is also controlled.
8. Importance of fiscal policy. The circular flow of income and expenditure points towards the importance of fiscal policy. For national income to be in equilibrium desired
I + G) S + T represent leakages from the spending stream which must be offset by injection of I + G into the income stream. If S + T exceed I + G exceed S + T the government should adjust its revenue and expenditure by encouraging saving and tax revenue. Thus the circular flow of income and expenditure tells us about the importance of compensatory fiscal policy
9. Importance of trade policies. Similarly, imports are leakages in the circular flow of money because they are payments made to a foreign country. To stop it, the government adopts such measures as to increase exports and decrease imports. Thus the circular flow points toward the importance of adopting export promotion and import control policies.
10. Basis of flow of funds accounts. The circular flow helps in calculating national income on the basis of the flow of finance accounts. The flow of finance accounts are concerned with all transactions in the economy that are accomplished by money transfers. They show the financial transactions among different sectors of the economy, and the link between savings and investment and lending and borrowing by them. To conclude, the circular flow of income possesses much theoretical and practical significance in an economy.
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