Circular flow of income

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In this simplified image, the relationship between the decision-makers in the circular flow model is shown. Larger arrows show primary factors, whilst the red n,.0p;smaller arrows show subsequent or secondary factors.

In economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers.[1][2] In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income.[1] Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households. More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports.

Human wants are unlimited and are of recurring nature therefore, production process remains a continuous and demanding process. In this process, household sector provides various factors of production such as land, labor, capital and enterprise to producers who produce by goods and services by coordinating them. Producers or business sector in return makes payments in the form of rent, wages, interest and profits to the household sector. Again household sector spends this income to fulfill its wants in the form of consumption expenditure. Business sector supplies them goods and services produced and gets income in return of it. Thus expenditure of one sector becomes the income of the other and supply of goods and services by one section of the community becomes demand for the other. This process is unending and forms the circular flow of income, expenditure and production.[3]

A continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning nor an end. The circular flow of income involves two basic assumptions:- 1.In any exchange process, the seller or producer receives the same amount what buyer or consumer spends. 2.Goods and services flow in one direction and money payment to get these flow in return direction, causes a circular flow.

Circular flows are classified as: Real Flow and Money Flow. Real Flow- In a simple , the flow of factor services from households to firms and corresponding flow of goods and services from firms to households is known to be as real flow.

Assume a simple two sector economy- household and firm sectors, in which the households provides factor services to firms, which in return provides goods and services to them as a reward. Since there will be an exchange of goods and services between the two sectors in physical form without involving money, therefore, it is known as real flow.

Money Flow- In a modern two sector economy, money acts as a medium of exchange between goods and factor services. Money flow of income refers to a monetary payment from firms to households for their factor services and in return monetary payments from households to firms against their goods and services. Household sector gets monetary reward for their services in the form of rent, wages, interest, and profit form firm sector and spends it for obtaining various types of goods to satisfy their wants. Money acts as a helping agent in such an exchange.

Two Sector Model (basic circular flow of income)[edit]

In the two sector circular flow of income model, the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is:

Y = E = O

This means that the expenditure of buyers (households) becomes income for sellers (firms). The firms then spend this income on factors of production such as labour, capital and raw materials, "transferring" their income to the factor owners. The factor owners spend this income on goods which leads to a circular flow of income.

Assumptions[edit]

The basic circular flow of income model consists of seven assumptions:

  1. The economy consists of two sectors: households and firms.
  2. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).
  3. All output (O) produced by firms is purchased by households through their expenditure (E).
  4. There is no financial sector.
  5. There is no government sector.
  6. There is no foreign sector

Three Sector Model[edit]

It includes household sector, producing sector and government sector. It will study a circular flow income in these sectors excluding rest of the world i.e. closed economy income. Here flows from household sector and producing sector to government sector are in the form of taxes. The income received from the government sector flows to producing and household sector in the form of payments for government purchases of goods and services as well as payment of subsides and transfer payments. Every payment has a receipt in response of it by which aggregate expenditure of an economy becomes identical to aggregate income and makes this circular flow unending.

Four Sector Model[edit]

A modern monetary economy comprises a network of four sector economy these are- 1.Household sector 2.Firms or Producing sector 3.Government sector 4.Rest of the world sector. Each of the above sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. Money facilitates such an exchange smoothly. A residual of each market comes in capital market as saving which inturn is invested in firms and government sector. Technically speaking, so long as lending is equal to the borrowing i.e. leakage is equal to injections, the circular flow will continue indefinitely. However this job is done by financial institutions in the economy. Reference- S. Dinesh Introduction to Macro Economics .

Five sector model[edit]

Table 1 All leakages and injections in five sector model

LEAKAGES INJECTION
Saving (S) Investment (I)
Taxes (T) Government Spending (G)
Imports (M) Exports (X)
  • LEAKAGES:-Leakage means withdrawal from the flow.When households and firms save part of their incomes it constitutes leakage. They may be in form of savings, tax payments, and imports. Leakages reduce the flow of income.
  • INJECTIONS:-Injections means introduction of income into the flow.When households and firms borrow the savings,they constitute injections.Injections increase the flow of income.Injections can take the forms of (a) investment,(b) government spending and (c) exports.So long as leakages are equal to injections circular flow of income continues indefinitely.Financial institutions or capital market play the role of intermediaries.
Circular flow of income diagram

The five sector model of the circular flow of income is a more realistic representation of the economy. Unlike the two sector model where there are six assumptions the five sector circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three more sectors introduced. The first is the Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing (savings from households) and lending of money. In terms of the circular flow of income model the leakage that financial institutions provide in the economy is the option for households to save their money. This is a leakage because the saved money can not be spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector. An example of a group in the finance sector includes banks such as Westpac or financial institutions such as Suncorp.

The next sector introduced into the circular flow of income is the Government Sector that consists of the economic activities of local, state and federal governments. The leakage that the Government sector provides is through the collection of revenue through Taxes (T) that is provided by households and firms to the government. For this reason they are a leakage because it is a leakage out of the current income thus reducing the expenditure on current goods and services. The injection provided by the government sector is Government spending (G) that provides collective services and welfare payments to the community. An example of a tax collected by the government as a leakage is income tax and an injection into the economy can be when the government redistributes this income in the form of welfare payments, that is a form of government spending back into the economy.

The final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to an open economy. The main leakage from this sector are imports (M), which represent spending by residents into the rest of the world. The main injection provided by this sector is the exports of goods and services which generate income for the exporters from overseas residents. An example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter of the wool (the farmer) therefore more money enters the economy thus making it an injection. Another example is China processing the wool into items such as coats and Australia importing the product by paying the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.

In terms of the five sector circular flow of income model the state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy. This can be shown as:

Savings + Taxes + Imports = Investment + Government Spending + Exports

OR

S + T + M = I + G + X.

This can be further illustrated through the fictitious economy of Martinland where:

S + T + M = I + G + X
$100 + $150 + $50 = $50 + $100 + $150
$300 = $300

Therefore since the leakages are equal to the injections the economy is in a stable state of equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of equilibrium the sum of total leakages does not equal the sum of total injections. By giving values to the leakages and injections the circular flow of income can be used to show the state of disequilibrium. Disequilibrium can be shown as:

S + T + M ≠ I + G + X

Therefore it can be shown as one of the below equations where:

Total leakages > Total injections

$150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + 150 (X)

Or

Total Leakages < Total injections

$50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + 150 (X)

The effects of disequilibrium vary according to which of the above equations they belong to.

If S + T + M > I + G + X the levels of income, output, expenditure and employment will fall causing a recession or contraction in the overall economic activity. But if S + T + M < I + G + X the levels of income, output, expenditure and employment will rise causing a boom or expansion in economic activity.

To manage this problem, if disequilibrium were to occur in the five sector circular flow of income model, changes in expenditure and output will lead to equilibrium being regained. An example of this is if:

S + T + M > I + G + X the levels of income, expenditure and output will fall causing a contraction or recession in the overall economic activity. As the income falls (Figure 4) households will cut down on all leakages such as saving, they will also pay less in taxation and with a lower income they will spend less on imports. This will lead to a fall in the leakages until they equal the injections and a lower level of equilibrium will be the result.

The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the levels of income, expenditure and output will greatly rise causing a boom in economic activity. As the households income increases there will be a higher opportunity to save therefore saving in the financial sector will increase, taxation for the higher threshold will increase and they will be able to spend more on imports. In this case when the leakages increase they wisituation will be a higher level of equilibrium.

Godley model (sectoral financial balances)[edit]

Sectoral financial balances in U.S. economy 1990-2012. By definition, the three balances must net to zero. Since 2009, the U.S. capital surplus and private sector surplus have driven a government budget deficit.

British economist Wynne Godley developed a sectoral analysis framework for macroeconomic analysis of national economies. The Godley model is also called the sectoral financial balances model. Economist Martin Wolf explained in July 2012 that government fiscal balance is one of three major financial sectoral balances in the national economy, the others being the foreign financial sector and the private financial sector. The sum of the surpluses or deficits across these three sectors must be zero by definition. Hence, a foreign financial surplus (or capital surplus) exists because capital is imported (net) to fund the trade deficit. Further, there is a private sector financial surplus due to household savings exceeding business investment. By definition, there must therefore exist a government budget deficit so all three net to zero. The government sector includes federal, state and local. For example, the U.S. government budget deficit in 2011 was approximately 10% GDP (8.6% GDP of which was federal), offsetting a capital surplus of 4% GDP and a private sector surplus of 6% GDP.[4]

Wolf argued that sudden shifts in the private sector from deficit to surplus forced the government balance into deficit, and cited as example the U.S.: "The financial balance of the private sector shifted towards surplus by the almost unbelievable cumulative total of 11.2 per cent of gross domestic product between the third quarter of 2007 and the second quarter of 2009, which was when the financial deficit of US government (federal and state) reached its peak...No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009, because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust."[4]

Economist Paul Krugman also explained in December 2011 the causes of the sizable shift from private deficit to surplus: "This huge move into surplus reflects the end of the housing bubble, a sharp rise in household saving, and a slump in business investment due to lack of customers."[5]

Description[edit]

Flows are derived from the National Accounting relationship between aggregate spending and income. So:

(1) Y = C + I + G + (X – M)

where Y is GDP (income), C is consumption spending, I is investment spending, G is government spending, X is exports and M is imports (so X – M = net exports).

Another perspective on the national income accounting is to note that households can use total income (Y) for the following uses:

(2) Y = C + S + T

where S is total saving and T is total taxation (the other variables are as previously defined).

You than then bring the two perspectives together (because they are both just “views” of Y) to write:

(3) C + S + T = Y = C + I + G + (X – M)

You can then drop the C (common on both sides) and you get:

(4) S + T = I + G + (X – M)

Then you can convert this into the following sectoral balances accounting relations which allow us to understand the influence of fiscal policy over private sector indebtedness. Hence, equation (4) can be rearranged to get the accounting identity for the three sectoral balances – private domestic, government budget and external:

(S – I) = (G – T) + (X – M)

The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.

Another way of saying this is that total private savings (S) is equal to private investment (I) plus the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.

All these relationships (equations) hold as a matter of accounting and not matters of opinion.

Thus, when an external deficit (X – M < 0) and public surplus (G - T < 0) coincide, there must be a private deficit. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process.

Usage[edit]

In macroeconomics, the Modern Money Theory uses sectoral balances to define any transactions between the government sector and the non-government sector as a vertical transaction.

The government sector is considered to include the treasury and the central bank, whereas the non-government sector includes private individuals and firms (including the private banking system) and the external sector – that is, foreign buyers and sellers.[6]

In any given time period, the government’s budget can be either in deficit or in surplus. A deficit occurs when the government spends more than it taxes; and a surplus occurs when a government taxes more than it spends. Sectoral balances analysis states that as a matter of accounting, it follows that government budget deficits add net financial assets to the private sector. This is because a budget deficit means that a government has deposited more money into private bank accounts than it has removed in taxes. A budget surplus means the opposite: in total, the government has removed more money from private bank accounts via taxes than it has put back in via spending.

Therefore, budget deficits, by definition, are equivalent to adding net financial assets to the private sector; whereas budget surpluses remove financial assets from the private sector.

This is represented by the identity:

(G-T) = (S-I) – NX

where G is government spending, T is taxes, S is savings, I is investment and NX is net exports.

The conclusion drawn from this is that private net saving is only possible if the government runs budget deficits; alternately, the private sector is forced to dis-save when the government runs a budget surplus.

A

Significance of Study of Circular Flow of Income[edit]

The book A General Approach to Macroeconomic Policy [7][citation needed] identifies four possible areas of significance:

  1. Measurement of National Income - National income is an estimation of aggregation of any of economic activity of the circular flow. It is either the income of all the factors of production or the expenditure of various sectors of economy. However, aggregate amount of each of the activity is identical to each other.
  2. Knowledge of Interdependence - Circular flow of income signifies the interdependence of each of activity upon one another. If there is no consumption, there will be no demand and expenditure which in fact restricts the amount of production and income.
  3. Unending Nature of Economic Activities - It signifies that production, income and expenditure are of unending nature, therefore, economic activities in an economy can never come to a halt. National income is also bound to rise in future.
  4. Injections and Leakages

Difference between Real Flow and Money Flow[edit]

  1. Real flow is the exchange of goods and services between household and firms whereas money flow is the monetary exchange between two sectors.
  2. In real flow household sector supplies raw material, land, labour, capital and enterprise to firms and in return firms sector provides finished goods and services to household sector. Whereas in money flow, firm sector gives remuneration in the form of money to household sector a wages and salaries, rent, interest etc.
  3. Difficulties of barter system for the exchange of goods and factor services between households and firms sector in real flow, whereas no such difficulty or inconvenience arise in money flow.
  4. When goods and services flow from one sector of the economy to another, it is known as real flow.

Phases or Stages of Circular Flow of Income[edit]

Production, consumption expenditure and generation of income are the three basic economic activities of an economy that go on endlessly and are titled as circular flow of income. Production gives rise to income, income gives rise to demand for goods and services ; such a demand gives rise to expenditure and expenditure induces for further production. The whole process forms the basis for circular flow of income and related activities- production, income and expenditure are known as phases or stages of circular flow of income.

Further reading[edit]

  1. Sloman, John (1999). Economics, 3rd edition. Prentice Economics. Europe: Prentice-Hall. ISBN 0-273-65574-4. 
  2. Mankiw, Gregory (2006). Principles of Economics. Thomson Europe. ISBN 1-84480-133-0. 

See also[edit]

References[edit]

  1. ^ a b Sloman, John. (1999), page 12
  2. ^ Mankiw, Gregory. (2006), page 23
  3. ^ Dinesh, S. Introduction to Macroeconomics
  4. ^ a b Financial Times-Martin Wolf-The Balance Sheet Recession in the U.S.- July 2012
  5. ^ NYT-Paul Krugman-The Problem-December 2011
  6. ^ "Deficit Spending 101 - Part 1 : Vertical Transactions" Bill Mitchell, 21 February 2009
  7. ^ A General Approach to Macroeconomic Policy.