2. The Circular Flow of Income and Expenditure – Macroeconomics: Theory and Policy

2

The Circular Flow of Income and Expenditure

After studying this topic, you should be able to understand

  • In a two sector economy, the sum total of the factor incomes earned by the households is equal to the total of the expenditures by the households on the goods and services.
  • There exist withdrawals and injections, which prevent the circular flow of income and money from remaining constant.
  • The main source of revenue for the government is through taxes.
  • The government may follow a balanced, deficit or a surplus budget.
  • A flow of income may exist between the government sector and the capital market.
  • The import and export of goods and services influence the circular flow of income.
  • In general, the exports of a country are rarely equal to the imports.
INTRODUCTION

A modern economy produces a variety of goods. Firms use the various factors of production–namely, land, labour, capital and entrepreneurship—to produce the goods that are then sold in the market. This chapter analyses the flow of the factors of production, goods and services, and money in two sector, three sector and four sector economies. It also includes a discussion on the various withdrawals and injections, which form a part of these economies. In any economy, there are following two kinds of flows:

  1. Real flows, which include the flows of the factors of production and the goods and services between the different sectors.
  2. Money flows, which include the monetary flows between the different sectors.

Real flows include the flows of the factors of production and the goods and services between different sectors.

Money flows include the monetary flows between different sectors.

Our discussion on the circular flow includes both the real flows and the money flows.

THE CIRCULAR FLOW OF INCOME IN A TWO SECTOR ECONOMY

In a two sector economy, there are only two sectors, households and firms. There is no government sector and no foreign sector. There exists a flow of services from the households to the firms and a corresponding flow of factor incomes from the firms to the households who own all the factors of production.

By definition, the national income is equal to the national expenditure. Thus, the sum total of the factor incomes earned by the households is equal to the total of the expenditures by the households on the goods and services. In any economy, for every transaction, there exists a seller and a buyer. Hence, every rupee of expenditure by a buyer must be accompanied by a rupee of income by the seller. Hence in a two sector economy, the total income earned by the households must be equal to the total expenditure in the economy.

BOX 2.1

The circular flow of income involves a process through which money and goods move between the different sectors in the economy. The concept of the circular flow was developed by Francois Quesnay, a French economist, in the eighteenth century. The model is used for analysing the macroeconomic relationships. It is used as the basis for studying macroeconomic relationships. The national income accounts also have the concept of the circular flow as their basis.

The firms are engaged in the task of production by combining the different factors of production; namely, land, labour, capital and entrepreneurship. The owners of these factors are the households, which receive wages for labour, rent on land, interest on the capital and profit on the entrepreneurship. The goods produced by the firms are bought by the households and the payments made by them for these goods and services are utilized by the firms to make the factor payments.

Assumptions

  1. Households spend all their income on the purchase of goods and services produced by the firms. In other words, there are no savings by the household sector.
  2. Firms produce the goods and services demanded by the households. However, the production by the firms is just enough to satisfy the demand by the households. In other words, there are no inventories.
  3. The firm distributes all that it earns from the sale of goods as wages, salaries, rent interest and profits. Thus, there are no retained earnings by the firms.

Figure 2.1 The Circular Flow of Income in a Two Sector Economy

Figure 2.1 depicts the circular flow of income in a two sector economy. It shows the economic transactions between the households and the firms. There are two loops: inner loop and outer loop.

Inner Loop: This represents the money flows. It consists of following two parts:

  1. The flow of factor incomes, namely, wages, rent, interest and profits from the firms to the households.
  2. The flow of expenditures on the goods and services from the households to the firms.

Outer Loop: This represents the real flows. It consists of following two parts:

  1. The flow of factor services including land, labour, capital and entrepreneurship from the households to the firms.
  2. The flow of goods and services from the firms to the households.

Figure 2.1 also depicts two ways of calculating the national income:

  1. as the total income from the production of the goods and services which equals the sum of wages, rent, interest and profits. In Figure 2.1, this is represented by the top half of the circular flow of money or, in other words, by the top half of the inner loop.
  2. as the total expenditure on the goods and services. In Figure 2.1, this is represented by the bottom half of the circular flow of money or, in other words, by the bottom half of the inner loop.
BOX 2.2

A more realistic model is the five sector model of the circular flow of income. It relaxes all the assumptions made in the two sector model. The five sectors in the model include the households, firms, government, the foreign sector and the financial sector. In such a model also, the equilibrium occurs when the total leakages equal the total injections in the economy.

These two alternative ways of calculating the national income have to be equal as the expenditure on the goods and services (according to the accounting rules) is income for the sellers of the goods and services.

Withdrawals and Injections in an Economy

Before we embark on a discussion of the three and four sector economies, it is necessary to throw light on the concept of withdrawals and injections.

 

Withdrawal is income, which is generated in the production of the national output and which does not become a part of the circular flow of income.

The circular flow of income and money would remain constant as long as what is spent on the goods and services by the households is all distributed by the firms as factor payments. However, reality presents a different picture where there exist withdrawals and injections of income, which prevent the circular flow of income and money from remaining constant.

Withdrawal (or leakage) is income, which is generated in the production of the national output and which does not become a part of the circular flow of income. There are three types of withdrawals: saving, taxes and imports.

We had assumed that households spend all their income on the purchase of goods and services produced by the firms. This implies that there are no savings by the household sector. However, in reality every individual in an economy saves. Thus,

 

  S = Y – C
where, S = saving
  Y = income
  C = consumption

As saving represents income not consumed, the very act of saving implies a reduction in the consumption expenditures. Thus, saving is a withdrawal of income and leads to a decrease in the income level. The savings by the firms also represent a withdrawal and lead to a decrease in the income level. Similarly, taxes and imports represent withdrawals and hence lead to a decrease in the circular flow of income.

Injection is an amount of money, which is spent by the different sectors in the economy and which is in addition to their incomes generated in the circular flow of income. There are following three types of injections, which are as follows:

  1. Investment
  2. Government expenditure
  3. Exports

Injection is an amount of money, which is spent by different sectors in the economy and which is in addition to their incomes generated in the circular flow of income.

Investment includes expenditure on plant and equipment, machinery and inventories. Investment expenditures are incurred by the firms to facilitate the process of production. It is financed from retained earnings, borrowings from the capital market, banks and others. These activities result in an addition to the circular flow of income.

Similarly, government expenditure and exports represent injections and hence lead to an increase in the circular flow of income.

The circle of money flowing through the economy is as follows: total income is spent (with the exception of ‘leakages’ such as consumer savings), while that expenditure allows the sale of goods and services, which in turn allows the payment of income (such as wages and salaries). Expenditure based on borrowings and existing wealth—i.e., ‘injections’ such as fixed investment—can add to total spending.

In equilibrium, the leakages are equal to the injections and the size of the circular flow remains the same. If injections are greater than the leakages, the circular flow will grow and there is prosperity in the economy. If on the other hand injections are less than leakages, the circular flow will become smaller in size and there is recession in the economy.

Figure 2.2 Withdrawals and Injections in an Economy

Figure 2.2 depicts withdrawals as deductions and injections as additions to the circular flow of income. As far as the household sector is concerned, withdrawals take the form of saving, personal income tax, sales tax, and imports whereas injections include government expenditures. As far as the firms are concerned, withdrawals take the form of corporation tax, business taxes and business savings whereas injections include government expenditures, investment expenditures and exports of goods and services.

RECAP
  • In an economy, by definition, the national income is equal to the national expenditure.
  • In a two sector economy, the inner loop represents the money flows whereas the outer loop represents the real flows.
  • Withdrawal is the income, which is generated in the production of the national output and which is not part of the circular flow of income.
  • Injection is an amount of money, which is spent by the different sectors in the economy and which is in addition to their incomes generated in the circular flow of income.
THE CIRCULAR FLOW IN A THREE SECTOR ECONOMY

Till now, we have discussed a two sector economy. We now introduce a third sector, the government sector. The inclusion of the government sector makes the model more realistic as the government plays an important role in the economy.

Just like any other sector in the economy, the government is involved in many activities.

  1. It raises its revenue from many sources. However, its main source of revenue is taxes. For the sake of keeping our analysis simple, we assume that taxes form the only source of revenue for the government. These taxes include:
    1. Taxes levied on the household sector: These can be direct taxes like the income tax or indirect taxes like the sales tax and excise duties on the consumer goods.
    2. Taxes levied on the firms: These can be direct taxes like the corporate income tax or indirect taxes like the sales tax and excise duties.

    Thus, we have

     

                  T = TH + TF
    where, T = total taxes
               TH = taxes levied on the households sector
                TF = taxes levied on the firms

     

  2. It has to incur expenditure on many heads. They include government expenditure on administration, justice, defense, development, social welfare activities, subsidies and so on. We can divide the government expenditures under four heads:
    1. Payments made to the household sector for the services rendered by them; for example, for those working in the armed forces, civil services and others.
    2. Payments made to the firms for the goods and services bought from them.
    3. Subsidies given to the firms to encourage production in certain areas and in certain sectors in the economy.
    4. Payments made for social security and welfare; these include pensions, unemployment compensations and other transfer payments.

      Thus, we have

     

                  G = GH + GF + Gs + GT
    where, G = total government expenditure.
              GH = payments made to the household sector for the services rendered by them.
              GF = payments made to the firms for the goods and services bought from them.
              Gs = government subsidies to the firms.
              GT = government payments for social security and welfare.

Like an individual, the government may follow a balanced, deficit or a surplus budget. The classical economists are in favour of a balanced budget where the government expenditure is always equal to the government revenue or where G = T. Hence, the amount of income withdrawn from the circular flow as taxes re-enters the flow as government expenditure.

In today’s world, the government often follows a deficit budget. Often, the government expenditure is much greater than their revenue or G > T. The difference is financed from loans from the capital market. Such a budget implies net injections and thus an expansion in the circular flow of income.

In a surplus budget, the government expenditure is less than their revenue or G < T. Such a budget implies net withdrawals and thus a contraction in the circular flow of income.

Figure 2.3 depicts the circular flow of income in a three sector economy. It shows the economic transactions between the households, firms and the government sector. There are the same two loops of a two sector economy. It is important to note that:

  1. a part of the flows between the households and the firms now gets diverted to the government sector;
  2. a part of the household income goes to the government sector in the form of taxes;
  3. a part of the firms’ earnings go to the government sector in the form of taxes;
  4. a part of the tax revenue is spent by the government as government expenditure on services and transfer payments to the household sector; and
  5. a part of the tax revenue is spent by the government as government expenditure on goods and subsidies to the firms.

Figure 2.3 The Circular Flow of Income in a Three Sector Economy

In addition, a flow of income between the government sector and the capital market may also exist.

  1. In case the government follows a deficit budget and the government expenditure is greater than the revenue or G > T, the difference is financed from loans from the capital market. Hence, money will flow from the capital market to the government sector.
  2. In case the government follows a surplus budget and the government expenditure is less than the revenue or G < T, money will flow to the capital market from the government sector. However, in today’s world this seems to be a rare occurrence.
RECAP
  • Taxes levied by the government include those on the households sector and those on the firms.
  • In today’s world, the government often follows a deficit budget, which implies net injections into the economy and thus an expansion in the circular flow of income.
  • For a deficit budget, money flows from the capital market to the government sector.
THE CIRCULAR FLOW OF INCOME IN A FOUR SECTOR ECONOMY

No economy in the world functions in isolation. It is linked with the other economies through trade. This brings us to an analysis of a four sector economy where besides the household, firms and the government, the fourth sector is the foreign sector.

Although the foreign sector is engaged in many activities, we will here concentrate only on the import and export of goods and services.

  1. When a country imports goods and services, the expenditure incurred by the residents of the domestic country leads to an increase in the income of the factors of production of the country which is exporting the goods and services (and not the domestic country). Hence, imports lead to an outflow of income and thus to a decrease in the circular flow of income.

    Figure 2.4 The Circular Flow of Income in a Four Sector Economy

  2. When a country exports goods and services, the expenditure incurred by the residents of the foreign country leads to an increase in the income of the factors of production in the domestic country which is exporting the goods and services. Hence, exports lead to an inflow of income and thus to an increase in the circular flow of income.

    Rarely does a situation occur where the exports of a country equal the imports. In general, two situations are possible:

    1. The exports of a country are less than its imports or X < M: Hence, there is a foreign trade deficit equal to (M – X) or an unfavourable balance of trade. As imports are greater than imports, or in other words, withdrawals are greater than injections there will be a decrease in the circular flow of income.
    2. The exports of a country are greater than its imports or X > M: Hence, there is a foreign trade surplus equal to (X – M) or a favourable balance of trade. As exports are greater than imports, or in other words, injections are greater than withdrawals there will be an increase in the circular flow of income.

Figure 2.4 depicts the circular flow of income in a four sector economy. It shows the economic transactions between the households, firms, government and the foreign sector. The figure is an extension of figure 2.3 where the bottom part of the figure depicts the foreign sector. Though the exports of goods and services add to the circular flow of income, imports of goods and services reduce the circular flow of income. (In a four sector economy, we have discussed only a simple model which does not include the other aspects of foreign trade as this will complicate the analysis.)

RECAP
  • Imports lead to an outflow of income and hence to a decrease in the circular flow of income.
  • Exports lead to an inflow of income and hence to an increase in the circular flow of income.
  • When the exports of a country are less than its imports or X < M, there is a foreign trade deficit equal to M – X or an unfavourable balance of trade.
  • When the exports of a country are greater than its imports or X > M, there is a foreign trade surplus equal to X – M or a favourable balance of trade.
SUMMARY
INTRODUCTION
  1. The chapter analyses the flow of the factors of production, goods and services, and money in two sector, three sector and four sector economies.
  2. In any economy, there are two kinds of flows: real flows, which include the flows of the factors of production and the goods and services between the different sectors; money flows, which include the monetary flows between the different sectors.
THE CIRCULAR FLOW OF INCOME IN A TWO SECTOR ECONOMY
  1. In a two sector economy, there are only two sectors: households and firms.
  2. By definition, the national income is equal to the national expenditure. In a two sector economy, the total income earned by the households must be equal to the total expenditure in the economy.
  3. The firms are engaged in the task of production by combining the different factors of production.
  4. The owners of these factors are the households.
  5. The goods produced by the firms are bought by the households and the payments made by them for these goods and services are utilized by the firms to make the factor payments.
  6. Assumptions: There are no savings by the household sector; there are no inventories; there are no retained earnings by the firm.
  7. The circular flow of income in a two sector economy can be depicted in a diagram showing the inner and the outer loops.
WITHDRAWALS AND INJECTIONS IN AN ECONOMY
  1. Withdrawal (or leakage) is income, which is generated in the production of the national output and which does not become a part of the circular flow of income.
  2. There are three types of withdrawals in an economy: saving, taxes and imports. Withdrawals lead to a decrease in the circular flow of income.
  3. Injection is an amount of money, which is spent by the different sectors in the economy and which is in addition to their incomes generated in the circular flow of income.
  4. There are three types of injections in an economy: investment, government expenditure and exports.
THE CIRCULAR FLOW IN A THREE SECTOR ECONOMY
  1. We now introduce a third sector, the government sector.
  2. It is assumed that taxes form the only source of revenue for the government. These taxes include those levied on the households sector and those levied on the firms.
  3. We can divide the government expenditures under four heads: payments made to the household sector, payments made to the firms for the goods and services bought from them, subsidies given to the firms and payments made to social security and welfare.
  4. The government may follow a balanced, deficit or a surplus budget. In today’s world, the government often follows a deficit budget. Such a budget implies net injections and thus an expansion in the circular flow of income.
  5. It is important to note that a part of the flows between the households and the firms now gets diverted to the government sector. In addition, a flow of income between the government sector and the capital market may also exist.
THE CIRCULAR FLOW IN A FOUR SECTOR ECONOMY
  1. In a four sector economy besides the household, firms and the government, the fourth sector is the foreign sector.
  2. Imports lead to an outflow of income and thus to a decrease in the circular flow of income.
  3. Exports lead to an inflow of income and thus to an increase in the circular flow of income.
  4. When the exports of a country are less than its imports or X < M, there is a foreign trade deficit equal to M – X or an unfavourable balance of trade.
  5. When the exports of a country are greater than its imports or X> M, there is a foreign trade surplus equal to X – M or a favourable balance of trade.
REVIEW QUESTIONS
TRUE OR FALSE QUESTIONS
  1. Real flows include the flows of money between the different sectors.
  2. In a two sector economy, the national income is equal to the national expenditure.
  3. Withdrawal is income, which is generated in the production of the national output and which does not become a part of the circular flow of income.
  4. Injection is an amount of money, which is spent by the different sectors in the economy and which is generated in the circular flow of income.
  5. A surplus budget implies net injections and thus an expansion in the circular flow of income.
VERY SHORT-ANSWER QUESTIONS
  1. Which are the two kinds of flows in an economy?
  2. Name the different types of withdrawals in an economy.
  3. Name the different types of injections in an economy.
  4. Name some of the taxes levied on the household sector and the firms.
  5. ‘Rarely does a situation occur where the exports of a country equal the imports.’ Comment.
SHORT-ANSWER QUESTIONS
  1. ‘By definition, the national income is equal to the national expenditure.’ Explain for a two sector economy.
  2. What are the assumptions necessary for an analysis of a two sector economy?
  3. Depict the circular flow of income in a two sector economy explaining the inner and outer loops?
  4. With the help of a diagram, explain the two ways of calculating the national income.
  5. What are the implications of a balanced, deficit or a surplus government budget on the circular flow of income? Discuss.
LONG-ANSWER QUESTIONS
  1. Describe the circular flow of income in a two sector economy.
  2. What is a withdrawal? What are the different types of withdrawals in an economy? Discuss.
  3. What is an injection? What are the different types of injections in an economy? Discuss.
  4. In a three sector economy, like any other sector in the economy, the government is involved in many activities’. Comment.
  5. Describe the circular flow of income in a four sector economy.
ANSWERS
TRUE OR FALSE QUESTIONS
  1. False. Real flows include the flows of the factors of production and the goods and services between the different sectors.
  2. True. The sum total of the factor incomes earned by the households is equal to the total of the expenditures by the households on the goods and services. Hence in a two sector economy, the total income earned by the households must be equal to the total expenditure in the economy.
  3. True. Withdrawal or leakage is income, which is generated in the production of the national output and which does not become a part of the circular flow of income. There are three types of withdrawals: saving, taxes, and imports. They all lead to a decrease in the circular flow of income.
  4. False. Injection is an amount of money, which is spent by the different sectors in the economy and which is in addition to their incomes generated in the circular flow of income. There are three types of injections: investment, government expenditure and exports. They all lead to an increase in the circular flow of income.
  5. False. In a deficit budget, the government expenditure is much greater than their revenue or G > T. The difference is financed from loans from the capital market. Such a budget implies net injections and thus an expansion in the circular flow of income.