Circular Flow of Income

Dr. A K M Nazrul Islam

Associate Professor

School of Business and Entrepreneurship

Independent University, Bangladesh (IUB)
October 2024
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 Circular Flow of Income
⚫ The process of production is a continuous process. In it, various
factors of income (FOI) such as land, labor, capital &
entrepreneurship are combined together for the production of
goods & services.
⚫ The supply of these FOP come from these FOP from households.
These factors offers their services to the producers (also known as
firms) who in returns produce goods & services & make payments
as reward in the form of rent, wages, interest & profits.
⚫ The households spend this money on goods & services produced
by the firms. Thus income or money first flows from the firms to
the households in the form of factor payments & then from the
households to the firms in the form of consumption expenditure.
⚫ The income continue to flow in a circular way so it is called
circular flow of income.

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 Two Sector Model
Goods & Services
Factor Services

Househo Industry
lds

Factor Payments
Payments for Goods & Services

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⚫ In the previous model, it is assumed that household sector and
firms do not save at all. But in actual practice it does not happen
so. Households save some part of their income for various
reasons like precautionary reasons, transactionary reasons
&speculative reasons.

▪ Similarly firms also save some of their receipts for reasons

like-expansion of their business etc.

⚫ All the banking institutions, insurance companies & financial

houses taken together constitute capital market of the economy.

⚫ From capital market these savings flow to firms as loans for

investment.
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Two Sector Model With Savings
Goods & Services

Factor Services

Savings Borrowings

Household Capital
Market Industry
s Savings
Borrowings

Factor Payments
Payment For Goods & Services

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 Three-Sector Model With Savings
Governm
ent Su
bs
ts In i
en dir dies
ec

Borrowings
ym tT

Savings
Pa es ax
a x es
T
Savings Borrowings
Capital
Households Market Industry
Savings
Borrowings

Factor Payments
Payment For Goods & Services

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 Four-Sector Model
Govt. receives
Factor Services loans
Governm Interest paid Rest of the world
t or ent Su
bs
ac al In idi
F dir
r + oci xes es

Borrowings
f e s ec
ns ent +S t Ta

s
Export
Savings
tT

Imports
a ax
Tr ym ent rec es
Pa ym cesDi
Pa rvi
Se Savings Borrowings
Capital
Households Market Industry
Savings
Borrowings

Factor Payments

Payment For Goods & Services

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 Withdrawals & Injections
⚫ In reality, however, there are leakages from and additions
to the circular flows of income and expenditure

⚫ The leakages and additions are also called withdrawals

and injections, respectively.

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 Withdrawals
⦿ Withdrawal is the amount that is set aside by the households and the
firms and is not spent on the domestically produced goods and services
over the period of time. Example a household sets aside a part of
income for old age or against the loss of job.

⦿ Saving is a withdrawal.

⦿ When savings are invested, they take a form of injections

⦿ 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 in anticipation of
depression

⦿ Such withdrawals reduce the size of circular flows

⦿ S+T+M (savings, taxes, imports)

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 Injections
⚫ Amount that is spent by households and firms in addition to
their incomes generated within the regular economy

⚫ Injection by the household may be in the form of spending

inherited savings or the hoarding

⚫ Firms can inject money by spending their retained earnings

or borrowing from outside

⚫ Injections increase the size of circular flows

⚫ I+G+X (investment, govt. exp., exports)

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 The circular flow of income

INJECTIONS

Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS

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 National Income
⚫ National Income (NI) refers to the money value of all final goods
& services produced by residents of a country while working
both within or outside the domestic territory in an accounting
year.

⚫ NI is expressed in monetary terms.

⚫ It reflects the value of final goods & services.

⚫ NI Is expressed over 1 financial year.

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 National Income- Meaning
⚫ It is a sum total of factor incomes accruing to normal
residents of a country within an accounting year.

⚫ The concept of National Income can be explained from

three sides –
I) Production
II) Income and
III) Expenditure

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 DEFINITIONS
⚫ Central Statistical Organization (CSO, India): -
“National Income is the sum total of factor incomes
earned by the normal residents of a country in the form
of wages, rent, interest and profit in an accounting
year”.

⚫ Prof. Kuznets: “The sum total of the market value of

final goods and services, produced by normal residents
of a country in one year is known as national product.”

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 National Income -Excluded Items
⚫ NI excludes sale & purchase of second hand goods.

⚫ It excludes income from illegal activities – smuggling, black

marketing, gambling etc.,

⚫ It does not includes transfer payments – old age pension,

scholarship to students etc.,

⚫ Transfer payment are those earning for which no contribution is

made to the flow of goods & services.

⚫ In other words they are not earned but received only.

⚫ T.P are received without doing or producing any commodity or

services. 15
Concepts/Aggregates of National Income
⚫ Gross Domestic Product at Market Price (GDPMP)
⚫ Gross National Product at Market Price (GDPMP)
⚫ Net National Product at Market Price (NNPMP)
⚫ Net Domestic Product at Market Price (NDPMP)
⚫ Gross Domestic Product at Factor Cost (GDPFC)
⚫ Gross National Product at Factor Cost (GNPFC)
⚫ Net National Product at Factor Cost (NNPFC)
⚫ Net Domestic Product at Factor Cost (NDPFC)
⚫ Private Income
⚫ Personal Income
⚫ Personal Disposable Income
⚫ National Disposable Income
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 Basic Concepts -
⚫ Domestic and National Concepts
1.Domestic Income = National Income – NFIA
2. National Income = Domestic Income + NFIA

⚫ Market Price and Factor Cost Concepts

1. Market Price = Factor Cost + NIT
2. Factor Cost = Market Price – NIT

⚫ Gross and Net Concepts

1. Gross Product = Net Product + Depreciation
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2. Net product = Gross Product – Depreciation
 Concepts related to
National Income (NNPFC)
⚫ GDP: Value of all final goods and services produced
within the domestic territory of a country during an
accounting year.

⚫ GNP = GDP + Net factor income from abroad

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Gross Domestic Product (GDP) Gross National Product (GNP)
It refers to the money value of all final It refers to the money value of all the
goods & services produced within the final goods & services by the normal
domestic territory of a country . residents of a country.

It is a domestic concept as it is It is a national concept because it is

concerned with the domestic territory of concerned with the normal resident of a
a country. country.

GDP = P(G) + P(S) GNP = GDP + NFIA

If we add net factor income from abroad If we subtract NFIA from it we get
to it, we get GNP. GDP.

GDP would be greater than GNP, if GNP>GDP if NFIA is positive.

NFIA is negative.

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 Net Domestic Product at Market Net National Product at Market Price
Price (NDPMP) (NNPMP)

It refers to the money value of all final It refers to the money value of all the
goods & services produced within the final goods & services by the normal
domestic territory in a year. residents of a country.

It is a domestic concept as it does not It is a national concept because it

include NFIA. includes NFIA

NDPMP = GDPMP – Depreciation NNPMP = GNPMP – Depreciation

= NNPMP - NFIA = NDPMP + NFIA

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Net Domestic Product (NDPMP) Net Domestic Product (NDPFC)/
Domestic income

It refers to the market value of all final It is the income received by the factors
goods & services produced both by of production while working within the
residents or non-residents within the domestic territory of the country in a
domestic territory of a country in an year.eg-Rent , Interest , Wages ,
accounting year. Profits

Net Indirect Taxes are included in it. Net Indirect Taxes are not included in
it.

NDPMP = NDPFC + Indirect Taxes - NDPFC = NDPMP – Indirect Taxes

Subsidies + Subsidies

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