Circular Flow of Income

What is Circular Flow of Income?

Macroeconomics tries to study the central questions of economies. Amongst these questions, the main question is how economies create wealth. In an economy, all factors of production (FoP) undergo a production flow/cycle; in the process of which it generates wealth in the form of making payments to the factor of production, known as factor payments. Thus, the economic wealth of nations is created by generating this flow and producing commodities (goods and services), which are then consumed by consumers who spend their income on these goods and services.  

Circular Flow of Income:

The circular flow of income is an economic model that reflects how money or income flows through the different sectors of the economy. A simple economy assumes that there exist only two sectors, i.e., Households and Firms. Households are consumers of goods and services and the owners of the factors of production (land labour, capital, and enterprise). However, the firm sector produces goods and services and sells them to households. 

In the circular flow of income (two-sector economy), there is an exchange of goods and services between the two players i.e., the firms and households, which leads to a certain flow of money in the economy. Households provide the firms with the factors of production, namely Land (Natural Resources), Labor, Capital, and Enterprise that generates goods and services, and consumers spend their income on the consumption of these goods and services. The firms then make factor payments to households in the form of rent, wages, interest, and profit. This flow of goods and services and factors payments between firms and households reflects the circular flow of money in an economy. 

Circular Flow in a Two-sector Economy (with Financial Market)

In the circular flow of an economy in a two-sector model without the financial market, it is assumed that no savings are made in the economy. It means that the households spend their entire income on the purchase of goods and services and every firm spends all the receipts from the sale of goods and services to make factor payments.

However, it does not happen in the actual world, i.e., households do not spend their entire income on the consumption of goods and services. Instead, they save a part of their income for the future. In the same way, the firms save some part of their receipts for the expansion of business or various other reasons. Besides, the firms also borrow money from outside to finance their expansion plans. All of these savings and borrowings happening in the economy are channelised through the financial market. Therefore, in a two-sector economy, the savings made by households accumulated in the financial market are used by the firms for investment purposes. 

Financial Market refers to those institutions like insurance companies, banks, etc., which transacts loanable funds in the economy. 

This concept can be better understood with the help of the following diagram:

Circular Flow in a Three-sector Economy

The government also plays a crucial role in the economic development of a country. Therefore, the circular flow of income in a three-sector economy includes households, firms, and the government sector. The government of a country acts as both a firm and a consumer. As a firm or producer, the government produces goods and services for the economy. However, as a consumer, it spends money on the consumption of goods and services produced by the firms. Besides the flows of circular income in the two-sector economy with a financial market, the additional flows due to the inclusion of the Government are:

1. Between Households and Government: The money from the government to households flows in an economy in two forms. First, in the form of transfer payments, such as old age pensions, scholarships, etc. Second, in the form of factor payments for hiring factor services of the households. This money flows back from households to the government in the form of direct taxes, such as interest tax, income tax, etc. 

2. Between Firms and Government: The money from firms to the government flows in an economy in the form of direct and indirect taxes. However, the money from the government to the firms flows into an economy in the form of subsidies. In this case, the government grants subsidies to the firms and makes payments to the firms for the purchase of goods and services produced by them. 

The financial market also plays an important role in a three-sector economy, as the government saves a part of their earned income and deposits the same in the financial market. Besides, the government also borrows money from the financial market so it can meet its expenditures. 

This concept can be better understood with the help of the following diagram:

Role of Government Sector in an Economy

The Government Sector of an economy performs the following activities:

1. It collects taxes from the households and firms.
2. It makes the payment for the purchase of goods and services from the firms.
3. It also makes transfer payments to the households and provides the firms with subsidies.
4. Lastly, Government saves and borrows money by taking help from the financial market. 

Circular Flow in a Four-sector Economy

Besides households, firms, and the government, the foreign sector also plays a crucial role in an economy. Therefore, the circular flow in a four-sector economy consists of households, firms, government, and the foreign sector. Money flows in each of these sectors are as follows:

1. Household Sector: The household sector of an economy provides factor services to the firms, government, and the foreign sector for which it received factor payments in return. Besides factor payments, the households also receive transfer payments like old age pensions, scholarships, etc., from the government and foreign sector. The household sector spends its earned income on Payments for goods and services purchased from firms, payments for imports, and tax payments to the government.

2. Firms: The firms receive revenue for the sale of goods and services from the government, households, and foreign sectors. They also receive subsidies from the government to produce goods and services. Besides, the firms make payments for taxes to the government, factor services to the households, and imports to the foreign sector. 

3. Government: The government receives revenue for the sale of goods and services, fees, taxes, etc., from the firms, households, and the foreign sector. It also makes factor payments to households and spends its revenue on transfer payments and subsidies. 

4. Foreign Sector: The foreign sector receives revenue for the export of goods and services from firms, households, and the government. It also makes payments to firms and the government for the import of goods and services, and households for the factor services. 

The financial market also plays an important role in a four-sector economy as the savings made by the households, firms, and the government gets accumulated here and this money is invested by the financial market in the form of loans to firms, households, and the government. The inflows of money in the financial market in a four-sector economy are equal to the outflows of money, which makes the circular flow of income continuous and complete. 

This concept can be better understood with the help of the following diagram: