Understanding the Circular Flow of Income

Posted on Apr 22, 2025 in Economy

Meaning of Circular Flow of Income

The circular flow of money refers to the process whereby money payments and receipts of an economy flow in a circular manner continuously over a period of time. The various components of money payments and receipts are saving, investment, taxation, loans, government purchases, exports, imports, etc. These are shown in a diagram in the form of current and cross-current in such a manner that the total money payments equal the total money receipts in the economy.

Circular Flow of Income

The modern economy is a monetary economy, where money is used in the process of exchange. The modern economy performs economic activities such as production, exchange, consumption, and investment. In order to carry out these economic activities, people are involved in buying and selling of goods and services. Transactions take place between different sectors of the economy. The process of production and exchange generates two kinds of flows:

• Product or real flow, that is, the flow of goods and services, and
• Money flow.

Product and money flow in opposite directions in a circular way. The product flow consists of a) factor flow, that is, the flow of factor services, and b) goods flow, that is, the flow of goods and services. In a monetized economy, the flow of factor services generates money flows in the form of factor payments which take the form of money flows. Factor payments and expenditure on consumer goods and services take the form of expenditure flow. Expenditure flow is a form of money flow. Both income and expenditure flow in a circular manner in opposite directions.

The entire economic system can therefore be viewed as circular flows of income and expenditure. The magnitude of these flows determines the size of national income. We can explain how these flows are generated and how they make the system work.

Economists, however, use simplified models to explain the circular flow of income and expenditure, dividing the economy into four sectors:

• I) Household sector,
• II) Business or Firms sector,
• III) Government sector, and
• IV) Foreign sector.

These sectors are combined to form the following three models for showing the circular flow of income:

• I) Two-sector model including the household and business sectors;
• II) Three-sector model including the household, business, and government sectors; and
• III) Four-sector model including the household, business, government, and the foreign sectors.

Circular Flow in a Two-Sector Economy

To begin with, consider a simple hypothetical economy where there are only two sectors, the household and business firms, which represent a closed economy with no government and no foreign trade. The household sector owns all the factors of production: land, labor, capital, and enterprise. This sector receives income in the form of rent, wages, interest, and profit by selling the services of these factors to the business sector. The business sector consists of producers who produce goods and sell them to the household sector.

Thus, in the first instance, money flows in the form of income payments such as rent, wages, interest, and profits from the business sector to the household sector when the former buys the services of the factors of production to produce goods. Money so received is, in turn, spent by the household sector to buy goods produced by the business sector. In this way, money flows in a circular manner from the business sector to the household sector and from the household sector to the business sector in the economy.

The analysis of the circular flow of income and expenditure in a two-sector closed economy is based on the following assumptions:

1. The economy consists of two sectors, namely, household and business or firms;
2. The household sector spends its entire income received in the form of rent, wages, interest, and profits from the business sector on buying goods and services produced by the firms. It does not hold or save any part of its income.
3. Business firms keep their production exactly equal to their sales or as much as demanded by the households. There are no changes in their inventories.
4. The business sector does not keep any undistributed money as a reserve. The money it receives by selling goods and services to the household sector is fully spent in making payments such as rent, wages, interest, and profits to the household sector.
5. There are no government operations.

Two-Sector Economy with Savings & Investment

In the analysis of the circular flow of income in a two-sector economy, we assumed that all money income received by households is spent on consumer goods and services. But in reality, households do not spend their entire money income on goods and services; they save a part of their income for various purposes. Let us now explain how savings affect the money flow in the economy if households save a part of their income.

1. All households deposit their savings with financial institutions/the financial market.
2. There are no inter-household borrowings.

In the following figure, a box in the middle of the circle represents the financial market. The money flow of savings is shown from households towards the financial market. Then, the flow of investment expenditure is shown as borrowing by business firms from the financial market.

If planned savings are more than planned investment expenditure, income, output, and employment will fall, and therefore, the flow of money will decline. On the contrary, if planned investment expenditure is more than planned savings, income, output, and employment will rise, and therefore, the flow of money will increase.

Circular Flow in a Three-Sector Economy

The two-sector economy model consists of households and business firms. But in a three-sector economy, an additional sector is the government sector. The government affects the economy in many ways. Here, we will concentrate on its taxing, spending, and borrowing roles. In the modern economy, the government plays a variety of roles. The government performs different functions. For this, it requires a huge amount of income.

The government receives income in the form of taxes from households and business firms. Taxes are paid by households and business firms, which not only reduce their disposable income but also their expenditure and savings.

Government spending includes expenditure on goods and services, pension payments, unemployment allowance, etc. Money spent by the government is an injection of income into the economy, which is further received by households and business firms.

In a three-sector economy, we have the following three economic agents:

1. Households and business firms
2. Financial sector
3. Government

The above figure clearly shows that income received by the government in the form of taxes from households and business firms is used for spending in the form of wages, salaries, allowances, pensions, subsidies, and purchases of goods and services from them. Money spent by the government is received by households and business firms.

Thus, leakages (withdrawals) in the form of savings and taxes arise in the circular flow of income. Savings and taxes are further injected back into the circular flow of income in the form of investment and government spending. When these leakages (withdrawals) are equal to injections in the form of investment and government spending, the flow of money in the economy operates smoothly.

Thus, it is symbolically expressed as:

Total expenditure (E) = C + I + G

Total income (Y) received is allocated to consumption (C), savings (S), and taxes (T).

Thus, symbolically expressed as:

Y = C + S + T

Since expenditure (E) made must be equal to the income received (Y), from the equations above, we have:

C + I + G = C + S + T

Since C occurs on both sides of the equation and will therefore be canceled out, we have:

I + G = S + T

By rearranging, we obtain:

G – T = S – I

Gross National Product (GNP)

GNP is the total market value of all final goods and services produced in a year, plus net income from abroad. This is the basic social accounting measure of total output or aggregate supply of goods and services. GNP includes four types of final goods and services:

1. First, consumer goods and services to satisfy the immediate needs and wants of the people.
2. Second, gross private domestic investment.
3. Third, goods and services produced by the government, and fourth, net income from abroad (i.e., net exports of goods and services).

GNP is the total amount of current production of final goods and services.