Circular Flow of Income

Circular Flow of Income

The circular flow of income is a model of an economy showing connections between different sectors of an economy. It shows flows of income, goods and services and factors of production between economic agents such as firms, households, government and nations. The circular flow analysis is the basis of national accounts and macroeconomics.

There are three models of circular flow of income, representing the major economic systems.

1. Two Sector Model: It is for a simple economy with households and firms.

2. Three Sector Model: It is for a mixed and closed economy with households, firms and government.

3. Four Sector Model: It is for an open economy with households, firms, government and rest of the world (External sector).

1. Circular Flow of Income in a Two-Sector Economy:

There are only two sectors namely, household sector and firm sector.

(i) Household Sector: The household sector is the sole buyer of goods and services, and the sole supplier of factors of production, i.e., land, labour, capital and organisation. It spends its entire income on the purchase of goods and services produced by the business sector. The household sector receives income from firm sector by providing the factors of production owned by it.

(ii) Firms: The firm sector generates its revenue by selling goods and services to the household sector. It hires the factors of production, i.e., land, labour, capital and organisation, owned by the household sector. The firm sector sells the entire output to households.

In a two- sector economy, production and sales are equal and there will be a circular flow of income and goods. The outer circle represents real flow (factors and goods) and the inner circle represents the monetary flow (factor prices and commodity prices). Real flow indicates the factor services flow from household sector to the business sector, and goods and services flow from business sector to the household. The basic identities of the two-sector economy are as under:

Y= C+I

Where

Y is Income; C is Consumption; I is investment

2. Circular Flow of Income in a Three-Sector Economy:

In addition to household and firms, inclusion of the government sector makes this model a three-sector model. The government levies taxes on households and firms,purchases goods and services from firms, and receive factors of production from household sector. On the other hand, the government also makes social transfers such as pension, relief, subsidies to the households. Similarly, Government pays the firms for the purchases of goods and services. 

The Flow Chart illustrates three-sector economy model:

Under three sector model, national income (Y) is obtained by adding Consumption expenditure (C), Investment expenditure (I) and Government expenditure (G).

Therefore:

Y= C+I+G

3. Circular Flow of Income in a Four-Sector Economy:

In a Four- sector economy, in addition to household, firms and government, a fourth sector namely, external sector is included. In real life, only four-sector economy exists. This model is composed of four sectors namely,

(i)  Households,        (ii) Firms,

(iii) Government, (iv) External sector

The external sector comprises exports and imports. It is illustrated in the Flow Chart.

In four-sector economy, expenditure for the entire economy include domestic expenditure (C+I+G) and net exports (X– M). Therefore,

Y = C + I + G + (X – M)