THE CIRCULAR FLOW OF INCOME

Dr. SK LAROIYA

UNIV OF DELHIAND

AMITY BUSINESS SCHOOL

TO UNDERSTAND THE METHODS OF MEASURING

NATIONAL INCOME IT IS NECESSARY TO SIMPLIFY THE COMPLEX NET WORK OF

NUMEROUS TRANSACTIONS CONDUCTED IN A MODERN ECONOMY

A SIMPLIFIED MODEL OF AN ECONOMY CAN BE CONSTRUCTED

IN WHICH

ALL TRANSACTIONS ARE CLASSIFIED IN A FEW BROAD

CATEGORIES DERIVED SPECIFICALLY FOR MEASURING NATIONAL INCOME

SUCH A MODEL WITH ITS VARIANTS, WOULD REPRESENT OVERALL ECONOMIC ACTIVITY IN THE FORM OF WHAT MAY BE CALLED

‘THE CIRCULAR FLOW OF INCOME’

WITH THESE MODELS

WE CAN DEMONSTRATE MACRO ECONOMIC EQUILIBRIUM, SO VITAL FOR THE ECONOMIC POLICY FORMULATION AND ITS EFFECTIVE IMPLEMENTATION

FOUR MODELS:

1. BASIC MODEL2. WITH SAVINGS AND INVESTMENTS3. WITH GOVERNMENT4. WITH FOREIGN TRADE

BASIC MODELSupply of goods and services

Household sector

Business sector

Payment of factor incomes: wages, interest, rent and profit

Factor services: lab.,land, capital , enterprise

Expenditure on goods and services

ASSUMPTIONS:1. ONLY TWO SECTORS IN THE ECONOMY: BUSINESS

AND HOUSEHOLD SECTORS2. HOUSEHOLD SECTOR SPENDS ALL THE MONEY IT

RECEIVES3. ALL THE INCOME OF BUSINESS SECTOR IS

EXHAUSTED IN MAKING FACTOR PAYMENTS4. HOUSEHOLD AND BUSINESS SECTOR DO NOT SAVE

ANY MONEY AND PAY NO TAXES5. IT IS A CLOSED ECONOMY

WITHDRAWAL:

A WITHDRAWAL CONSISTS OF ANY PART OF INCOME GENERATED IN PRODUCING NATIONAL PRODUCT WHICH IS PASSED ON WITH IN THE ECONOMY

1. SAVINGS2. IMPORTS3. TAXES

INJECTION:

AN INJECTION IS AN ADDITION TO THE CIRCULAR FLOW OF INCOME

1. INVESTMENT2. EXPORTS3. SUBSIDIES4. GOVERNMENT EXPENDITURE5. TRANSFER PAYMENTS

Supply of goods and services

Household sector

Business sector

Payment of factor incomes: wages, interest, rent and profit

Factor services: lab.,land, capital , enterprise

Expenditure on goods and services--- withdrawals

+ injections

- withdrawals

+ injections

MODEL WITH SAVINGS AND INVESTMENTSSupply of goods and services

Household sector

Business sector

Payment of factor incomes: wages, interest, rent and profit

Factor services: lab.,land, capital , enterprise

Expenditure on goods and services--- Bus. savings

+ Investments

- HH. savings

+ injections

National income= C + S

S= SH +SB

SH = household savingsSB = busines savings

National product= C + I

For Equilibrium:

Y=C + SY= C + IS= I

MODEL WITH GOVT. SECTORSupply of goods and services

Household sector

Business sector

Payment of factor incomes: wages, interest, rent and profit

Factor services: lab.,land, capital , enterprise

Expenditure on goods and services--- Bus. savings

+ Investments

- HH. savings

+ injections

-- Taxation

+Govt. exp. Inc.subsidies

Y= C+S+TY= C+I+GT=TAXESG=GOVT. EXPENDITURE

Y=C+I+GFOR EQUILIBRIUMC+I+T=C+I+GS+T=I+GS+(T-G)=I

MODEL WITH FOREIGN TRADE SECTORSupply of goods and services

Household sector

Business sector

Payment of factor incomes: wages, interest, rent and profit

Factor services: lab.,land, capital , enterprise

Expenditure on goods and services--- Bus. savings

+ Investments

- HH. savings

+ injections

-- Taxation

- Imorts

+Exports

+Govt. exp. Inc.subsidies

Y=C+S+T+MY=C+I+G+XFOR EQUILIBRIUMC+S+T+M=C+I+G+XS+T+M=I+G+XS+T=I+G+(X-M)X-M IS NET FOREIGN INVESTMENT.

PUTTING IF FOR X-MAND ID FOR DOMESTIC INV.

WE HAVES+T= ID+G+IFS+(T-G)=ID+IF

SO IN FOUR SECTOR MODEL WE HAVE

S+(T-G)=ID+(X-M)