Introduction

An economy consists of basic economics activities of production, consumption and investment.

These are vital processes of the economy because these are the basis of survival and growth of an
economy.

In carrying out these activities, producers produce goods and services, consumers buy these goods
and services and thereby generate income.

Income generated in the production process flows in a circular order.

It is called a circular flow as this is a continuous process; there is no end to it because there is no end
to human wants.
Circular Flow of Income

In carrying out economic activities like production, consumption and exchange, people are involved
in making transactions between different sectors of economy because of these transactions income
and expenditure move in a circular form in an economy. This is called circular flow of income.

In other words, circular flow of income refers to flow of money income or flow of goods and services
across different sectors of the economy in the circular form.

From Macro point of view, economy is often divided into four sectors:

1. Household Sector- It includes consumers of goods and service. Households are the owners of the
factors of production and provide factor services to the producer sector

2. Producer/Firm Sector - This sector includes all producing units or firms in the economy. To produce
goods and services, the firms hire factors of production (land, labour, capital and entrepreneur) from
the households and sell goods and services.

3. Government Sector - This sector produces goods and services for collective consumption. For
example - services of roads, dams, defence etc. Here, government promotes the well being of the
citizens.

4. External Sector/ Foreign Sector - This is also called rest of the world sector. It is engaged in export
and import of goods and services and the flow of loans and D investment between the domestic
economy and other countries of the world.
Phases/Stages of Circular Flow of Income

(i) Phase of Production -

• It refers to the process of value addition by the producing sector.

• The producer sector hires factor services from the household sector and by using other non
factor inputs, goods and services are produced.
• It is also known as Generation Phase.

* As there is no end to human wants there is no end to the process of production also.

(ii) Phase of Income Generation –

• For providing their factor services to the producers, the households get factor payments.
• In this phase of circular flow, there is generation or distribution of income as an outcome of
production of goods and services.
• It is also known as Distribution Phase.
• Value of production is converted into factor income after monetary value of goods and
services is distributed among factors of production.

(iii) Phase of Expenditure/Disposition

• Income is spent on purchase of final goods and services.

• When households purchase the final goods, there is consumption expenditure.
• When the producers purchase the final goods, there is investment expenditure.
• Thus in this phase, there is disposition of income as an outcome of generationof income.

Expenditure generates demand for goods and services; this causes production of goods and services
and consequently, generation of income.

Thus, the three flows of production, income and expenditure move in a circle. That is why; it is called
the circular flow.
Types of Circular Flow

1. Real Flow - Real Flow implies the flow of factor services from households to firms and goods and
services from firm to household.

• In simple words, real flow refers to flow of goods and services.

• It is also known as product flow/physical flow.

2. Money Flow - It refers to the flow of money across different sectors of the economy.

• In other words, money flow refers to flow of money in the form of factor payments and
consumption expenditure among different sectors.
• It is also known as nominal flow/income flow.
Differences between Real Flow and Money Flow

Models/Forms of Circular Flow of Income

1.Circular flow in a two sector Economy

1.Circular Flow Model in Simple Economy

(Two Sector Model without Saving)

Assumptions

(i) There are only two sectors (i.e. household and firm).

(ii) There is no saving.

(iii) There is no Govt. sector

(iv) There is no rest of the world (ROW) sector.

• Factor services flow from household sector to the producer sector (real flow).
• Factor payments flow from producer to household sector for their services (money flow).
• Final goods and services flow from producer to the household sector (real flow).
• Final consumption expenditure on goods and services flow from household to producer 2
sector (money flow) in exchange of goods and services.
 Conclusions:
1. Real Flow = Money Flow
2. Total Production = Total Consumption
3. Factor Payments = Factor Income
4. Factor Income = Consumption Expenditure
5. Consumption Expenditure by Households = Total Income of the Producers.

II. Circular Flow Model in Two Sector Economy With Financial Sector

(Two Sector Model with Saving)

Assumptions

(i) There are only two sectors (i.e. household and firm).

(ii) There is no Govt. sector.

(iii) There is no rest of the world (ROW) sector.

Financial system is essential for the working of modern economy.

Financial institutions are intermediaries between savers and investors.

• In reality household do not spend entire income on consumption. They save part of their
income.
• Similarly, firms may not distribute all their receipts to household; they may save a part of
their receipts in the forms of undistributed profits.
• Factor services flow from household sector to the producer sector (real flow 2
• Factor payments flow from producer to household sector for their services (money flow).
• Final goods and services flow from producer to the household sector (real flow).
• Final consumption expenditure on goods and services flow from household to producer
sector (money flow) in exchange of goods and services.
• Household sector and producer sector save and put savings in financial system.
• Household sector and producer sector borrow from the financial sector.

Conclusions:

1. Real Flow = Money Flow

2. Total Production = Total Consumption

3. Factor Payments = Factor Income

4. Consumption Expenditure by Households = Total Income of the Producers.

2. Circular Flow in a Three-sector Economy

Circular flow of income in a three-sector economy, consists of households, firms and the government
sector. Government plays a very important role in the economic development of a country. It acts as
both consumer and a firm. As a consumer, it spends on consumption of goods and services produced
by firms. As a producer, it produces goods and services for the economy. In addition to flows of
circular flow in two-sector economy with financial market, the introduction of Government leads to
following flows:

• Between Households and Government Money flows from government to households in the
form of:
(i) Transfer payments like scholarships, old age pension, etc.; and (ii) Factor payments for
hiring factor services of households.
• Money flows back to the government from households in the form of direct taxes like
income tax, interest tax, etc.
• Between Firms and Government Money flows from firms in the form of direct taxes and
indirect taxes.

Money flows to the firms from government, when the latter grants subsidies and makes payment to
the former for purchase of goods and services produced by the firms.

A part of the income earned by government is also saved and deposited in the financial market.
Government also borrows money from the financial market to meet its expenditure. A brief
summary of this circular flow is given in the following diagram:

3. Role of Government Sector in an Economy

Government Sector performs the following activities in the economy:

(a) Government collects taxes from households and firms.

(b) Government makes transfer payments to the households and provides subsidies to the firms.

(c) Government makes the payment for purchase of goods and services from the firms.

(d) Government saves and borrows money with the help of financial market.

4. Circular Flow in a Four-sector Economy

Circular flow of income in a four-sector economy consists of households, firms, government and
foreign sector. The various money flows in each sector are:

Household Sector: Households provide factor services to firms, government and foreign sector. In
return, it receives factor payments. Households also receive transfer payments from the government
and the foreign sector. Households spend their income on:

• Payment for goods and services purchased from firms;

• Tax payments to government;
• Payments for imports.

Firms: Firms receive revenue from households, government and the foreign sector for sale of
their goods and services. Firms also receive subsidies from the government. Firm makes
payments for: (i) Factor services to households; (ii) Taxes to the government; (iii) Imports to
the foreign sector.

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

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

The savings of households, firms and the government sector get accumulated in the financial
market. Financial market invests money by lending out money to households, firms and the
government. The inflows of money in the financial market are equal to outflows of money. It
makes the circular flow of income complete and continuous. The circular flow of income in a
four-sector economy is shown in Fig.
Expansion and Contraction of Circular Flow: Injections and Leakages

• A circular flow of income may expand or contract. Expansion of circular flow of income
implies a rise in the level of income/output in the economy.
• Contraction of circular flow of income, on the other hand, implies a fall in the level of
income/output in the economy.
• Expansion of circular flow occurs owing to 'injections', while contraction occurs owing to
'leakages'.

Importance/ Significance of Circular Flow of Income

1. Knowledge of interdependence among sectors - It helps us to understand inter dependence

among different sectors of the economy.

2. Identification of injections and leakages -These help in maintaining the identity among production,
income and expenditure. If there are leakages, circular flow reduces and if there are injections,
circular flow expands.

3. Estimation of National Income - National income is measure by three methods, production,

income and expenditure. The three phases of circular flow of income give us the identity among the
three methods as value of goods and services is same as income generation and income causes
expenditure.

4. Indicator of economic activity - The circular flow gives explanation on various macro variables viz.
national income, consumption, saving, employment etc. Accordingly, level of economic activity can
be ascertained. Level of economic activity causes income and product to flow in a circular manner.