Circular Flow of Income

Macro Economics Macroeconomics is a branch of economics field that

studies how the aggregate economy behaves. In macroeconomics, a variety of economy-wide

phenomena is thoroughly examined such as, inflation, price levels, rate of growth, national income, gross domestic product and changes in unemployment

Useful to estimate National Income and Per Capita Income

National Income (N.I.) N.I. Is the aggregate money value of goods and

services produced in a country during a particular year

It is the money value of all economic activities of a nation in a given year

Economy is in equilibrium when income = output = expenditure

National Income (N.I.) Economic Activities in National Income

Production Exchange Consumption Distribution

Above Decisions are based on Economic Agents Households Firm

National Income (N.I.) Household

Owners of Factors of Production Receive Income by supplying Services of Factors to

Firms Firms

Businesses who decide what, where, how and for whom to produce to goods and services

Receive Income by selling their output to household

Aspects of Circular Flow of N.I.

Real Flow Money Flow Movement of Factor

services from household to firms

Movement of Goods & Services from firms to Households

Movement of money as payment for factor services from firms to households

Movement of money as payment for goods & services from household to firms

Circular Flow of N.I. Closed Economy

Two Sector Economy (Without Savings) Two Sector Economy (With Savings)

Three Sector Economy Four Sector Economy / Open Economy

Closed Economy – Without Savings

Assumptions 2 Sectors only – Household and Firms Household owns Factors of Production Household receives payment for service of factors of

production Production Activities take place in Firms Only Both Household and Firms have ZERO Savings No Govt Operations or International Trade

Closed Economy – Without Savings

Closed Economy – With Savings Assumptions

2 Sectors only – Household and Firms Household owns Factors of Production Household receives payment for service of factors of

production Production Activities take place in Firms Only No Govt Operations or International Trade

Closed Economy – With Savings

Closed Economy – With Savings Savings are leakage from the circular flow of economy Households save a part of their income in form of Bank

Deposits or financial investments etc. Firms borrow money from banks or financial institutions

thus converting household savings into real investments Thus savings is injected back in economy in the form of

investment When savings are made circular flow of income is

disturbed due to leakage but is restored as real investments are made on account of injection

Three Sector Model (Firms, Household & Govt)

Four Sector Model (Firms, Household, Govt & External Sector)

Four Sector Model (Firms, Household, Govt & External Sector)

Savings, Taxes, Imports are leakages and Investment, Govt expenditure and exports are injections

Circular Flow of Economic Activities among 4 sector shows that there will be equilibrium in all sectors when

Savings = Investments Govt Expenditure = Taxes Exports = Imports

Four Sector Model (Firms, Household, Govt & External Sector)

To measure Circular Flow in various economies there are various stages as follows

Production Stage – Measured by Value of Output Income Stage – Measured by Earned Factor

Income Spending Stage – Measured by Extent of total

expenditure

Importance of Circular Flow of Income

Gives Clear Picture of Economy Smooth Functioning of Economy Guidance in Restoration of Equilibrium Helps to Find Leakages Highlights importance of Policies (Fiscal &

Monetary Policies for equality in income & expenditure)

Comprehensive Study of Economy’s Performance

Questions Analyze Circular Flow of Income in Closed

Economy Elucidate Circular Flow of Income in Open

Economy Explain Circular Flow of Income in 3 Sector

Economy Importance of Circular Flow of Income in

Economy