Circular flow of income

COURSE: BA

PAPER – 3 MACRO

MODULE- 2

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The circular flow of income forms the basis for all models of the macro-. We can understand, explain how national income, output and expenditure is created over time. Simply it is reflection of economy in dynamic situation.

Origin of the concept One of the earliest ideas on the circular flow was explained by 18th century Irish- French economist , in his 1730 Essay on the Nature of Trade in General. François Quesnay, French economist, further developed these concepts, and was the first to visualize interactions among economic agents over time in the so-called Tableau économique.

The first to visualize the modern circular flow of income model was Frank Knight in 1933 publication of The Economic Organization. Fully developed modern concept was presented by J.M. Keynes, who was popularly called the father of . Definition There are economic agents in the economy who are responsible to run the economy like consumers or , producers or entrepreneurs, traders, banks and governments. and services are exchanged among agents regularly to satisfy their needs or desires. For which everyone has to pay (sole medium of exchange) in return in the modern monetary economy. That money which pays or spends become the income to the receiver which flows from the one economic to the other in the year The real flow refers to the flow of factor services and flow of . The flow of factor services from the households to the firms and the flow of goods and services from firms to the is the real flow. The flow of factor services generates money flows in the form of which the firms pay the household and similarly the household need to pay the firms for the flow of goods and services.

The movement to the money/cash payment from one sector to the other sector corresponding to the real flow is referred to as the monetary flow. Thus, the income of one sector becomes the expenditure of the other and the supply of goods and services by one sector becomes the demand of the other sector. The real flow and monetary flow move in a circular manner in an opposite direction. A continuous flow of , income and expenditure is known as the circular flow of income.

Agents of the economy There are four main agents of the economy as per this circular flow of income:

1) Household sector(C) - supplies , consumes and create demand for goods and services 2) firms(I) – produce, supply of goods and services 3) The government(G)- provides regulation, supervision and permits economic activity, incurs expenditure and collect taxes 4) Foreign sector(X-M)- and of good and services

So, total our national income is the contribution of these four sectors separately and the combined result of interaction among them.

# GNI = C + I+G+(X-M)

TWO SECTOR CLOSED ECONOMY We can examine the nature and volume of income flow in a just two sector model without government and foreign sector:

A) Without saving and investment

The household sector supplies factors of production to firms and in return receives wages, rents as income. with that income they purchase the goods which are produced by firms. there is no saving and investment in this simple model of the economy. Income /money which started from firms after due course of time would again reach them from households. It is simple circular flow of income.

Thus, the income of the producers is equal to the income of the households is equal to the expenditure of the household. The demand of the economy is equal to the supply.

In this model, Y = C where, Y is Income and C is Consumption. This can be explained with the help of diagram

Diagram -1

Irconomics

With saving and investment

The saving by the household sector would imply monetary withdrawal (equal to saving) from the circular flow of income. This would affect the sale of the firms since the entire income of the household would not reach the firm. That saving is converted into investment by firms which are credited from financial institutions.

Here …comes the role of financial intermediaries in the equilibrium of economy. If the total investment (I) of the firms is equal to the total saving (S) of the household sector then the equilibrium level of the economy would be maintained at the original level.

The equilibrium condition for a two-sector model with saving and investment is as follows:

Y = C + S or Y = C + I or C + S = C + I Or, S = I

Where, Y = Income, C = Consumption, S = Saving and I = Investment

Three sector model with closed economy: Now in addition to the above two sectors- household and firms, adding one more sector i.e. government. It has its own role and contribution in the circular flow of income, thereby, the national income through its fiscal policies- revenue and expenditure.

This sector adds three key elements to the circular flow model, i.e., taxes, government purchases and government borrowing. The government levies taxes on the households and the firms and it also gives subsidies to the firms and transfer payments to the household sector.

Thus, there is income flow from the household and firms to the government via taxes in one direction and there is income outflow from the government to the household and firms in the other direction. If the government revenue falls short of its expenditure, go to borrowing through financial markets.

Diagram2

USA

In this model, the equilibrium condition is as follows:

# Y = C + I + G

Where, Y = Income; C = Consumption; I = Investment and

G = Government Expenditure

OPEN ECONOMY MODEL WITH FOUR SECTORS

If we take now four sectors including the foreign sector it becomes open economy model. This is full-fledged circular flow model. Here foreign sector also plays major role in the functioning of the circular flow of income of a country by foreign trade. Income is generated from of goods and services and expenditure is incurred on from the outside. The import payments and export receipts transactions are done in the financial .

Diagram-3

wikimedia

In this model, the equilibrium condition is as follows:

# Y = C + I + G + (X-M)

Where, Y = Income; C = Consumption; I = Investment; G = Government Expenditure; X = Exports and M = Imports.

X-M = Net Exports LEAKAGES AND INJECTIONS OF THE ECONOMY

There are some leakages from this circular flow of income which goes out of this like saving, taxes and imports. They go to banks, government and foreign country, not spend in domestic goods and services market so volume of income would be declined

Some are injections which are added to circular flow of the economy like investment by firms, expenditure by the government and exports earnings so that volume of income would be increased.

For equilibrium of an open economy leakages must be equal to injections

Balance= S+ T+ M = I+G+ X Where

S = Saving; T = Taxes; and M = Imports

I = Investment; G = Government Expenditure; and X = Exports

IMPACT OF COVID 19 ON CIRCULAR FLOW OF THE ECONOMY

In a pandemic uncertain situation like covid-19 and lock down -people are insecure of their jobs and earnings, try to save their money instead of spending for the future. Business firms also face low demand for goods and services, see decline in their profit. Banks are shy of giving credits to entrepreneurs. As a result investment plummeted in a short time.

Government collects low taxes from firms and families, get low revenue but its expenditure will be abnormally increased on economic rehabilitation packages so its debt would be raised.

There would-be low imports and at the same time low exports due to lockdown worldwide which impact worst on global GDP growth in the coming days.

Finally, all injections are failed in this period, leakages are increased which leads to low or negative national income growth in many countries including India in 2020-21.

References: https://en.wikipedia.org/wiki/Circular_flow_of_income https://commons.wikimedia.org/wiki/File:Circular_flow_of_income.jpg http://en.citizendium.org/wiki/File:Economics_circular_flow_cartoon.jpg https://www.economicsonline.co.uk/Managing_the_economy/The_circular_flow_o f_income.html e-pg pathashala of MHRD

Content Generator:

D. RAMANJULU

LECURERIN ECONOMICS

[email protected]

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