The Economy as a Circular Flow

of Income and Expenditure

The Circular Flow of Income and Expenditure

In an economy millions of people are buying, selling, working, hiring.
Since economy as an integrated system of production, exchange and
consumption, it has two types of decision makers
1. Producers(Seller): who produces goods and services and sale in
the market , receives income
2. Consumer ( Buyer): who spends money in exchange for goods
and services bought , made expenditure
Buy and sell goods and services
Production flow ( Income)
Money Flow ( Expenditure)
So total income = total expenditure at a point of time
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The Circular Flow of Income and Expenditure

Economic Agents
1. Individual/Households/Society
2. Firms/Industry
3. Government
4. External Sector
So we have circular flow of Income and Expenditure for
1. One Sector
2. Two Sector
3. Three Sector
4. Four Sector
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The Circular Flow of Income and Expenditure:

One Sector Model

Households in the only one sector

Ex, Robinson Crusoe , who lived an island
Whatever it produces, it consumes
So his aggregate supply AS=Y=f (N)
His aggregate demand AD=C
Equilibrium: AD= AS
=>Y=C
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The Circular Flow of Income and Expenditure:

Two Sector Model
Two Sector:
1. Households:
1.
2.
3.
4.

Owner of all factors of productions: La, L, K, O

Total income= R+w+i+p
Consumes goods and services
Made Expenditure on goods and services

2. Firms/Industry:
1.
2.
3.
4.
5.

They own no resources of their own

Hire and use factors of production: La, L, K, O
Make Factor Payments
Produces and sell goods and services to households
No saving
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The Circular Flow of Income and Expenditure:

Two Sector Model
Assumptions:
Only two sectors Consumers(Household) and
Producers(Firms)
All production is sold to the consumers
Producers provide all the Goods and Services, no
inventory. Make factor payment R, w, i and p
Consumers spend all their Income on goods an
services. No Savings. Consumers are the owners of
productive resource - land, labour, capital and
enterprise
No government and no overseas sectors
No inflow or outflow of income or goods and services
outside or inside.

The Circular Flow of Income and Expenditure:

Two Sector Model

The Circular Flow of Income and Expenditure:

Two Sector Model
Important Identities:
Household Income (Y)
Firms Factor Payment (FP)
Identity:

Y=FP
FP= R+w+i+p
Y R+w+i+p

Household Expenditure:(E)
Firms Supply of goods and services (Z)
Identity:
YV

E=Y
Y=V

Means
Households income (Y) Factor Payments (FP) Money Value of
Goods and Services (V)
So
Y FP V
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The Circular Flow of Income and Expenditure:

Two Sector Model
(With Savings and Investment)
Withdrawals and Injections:
Withdrawals: An amount that is set aside by the
households and firms and is not spent on
domestically produced goods and services over a period
of time
Ex. Savings is an withdrawals
Injections: An Injections is the amount that is spent by
households and firms in addition to that
income generated within a regulated
economy.
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Ex. Own hoarding or borrowing and spending

The Circular Flow of Income and Expenditure:

Two Sector Model
(With Savings and Investment)
Flow of Money

Flow of Goods and Services

All saving are made by households and entered to the firm through financial
markets,
So, S=I

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The Circular Flow of Income and Expenditure:

Three Sector Model
Three Sector:
1. Households
2. Firms/Industry
3. Government
1. Revenue: Direct taxes
2. Expenditure: Govt. spending on goods and services
3. Transfer payment: pension, unemployment benefit
If G=T balanced budget
If G>T deficit budget
If G<T surplus budget
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The Circular Flow of Income and Expenditure:

Three Sector Model

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The Circular Flow of Income and Expenditure:

Three Sector Model
Withdrawals
Taxes are withdrawals as they reduces the
pvt disposable income of the households
Injections
Govt Exp are injections as they add to
their income
Transfer payment are also injections as
they add income
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The Circular Flow of Income and Expenditure:

Four Sector Model
1. Households:
C
2. Firms/Industry
I
3. Government
Revenue: Direct taxes (T)
Expenditure: Govt. spending on goods and services (G)
Transfer payment (tr)
4. External Sector
Import (M)
Export(X)

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The Circular Flow of Income and Expenditure:

Four Sector Model
Assumptions:

The external sector consists of only exports(X) and

imports)

The export of goods and services and non-labour

services are only made by firms

Households only exports labor

If X>M net gain from trade

If X<M net loss from trade
If X=M leave the circular flow unaffected
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The Circular Flow of Income and Expenditure:

Four Sector Model

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The Circular Flow of Income and Expenditure:

Four Sector Model

Withdrawals
Imports are withdrawals as they
reduces the income of the households
Injections
Exports are injections as they add to
their income

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Thank You All

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Circular flow of Income and Expenditure:

Two Sector Model
Revenue
Goods & Services
sold

Spending
Market for
Goods
and Services
(Goods Flow)

Goods & Services

bought

Firms

Households

Inputs for production

Factor payment=Rent,
wages, interest and
profit

Market for
Factors
of Production
(Factor Flow)

Land, Labor, Capital

and Entrepreneur

Factor Income

Circular flow of Income and Expenditure:

Two Sector Model
Revenue
Goods & Services
sold

Firms

Spending
Market for
Goods
and Services
(Goods Flow)

Investment

Savings
Capital Market

Inputs for
production

Rent, wages,
interest and profit

Goods & Services

bought

Market for
Factors
of Production
(Factor Flow)

Households

Land, Labor,
Capital and
Entrepreneur
Income

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Wages, Salaries and transfer Payment

Govt Purchse and Subsidies

Direct and indirect Taxes

Direct Taxes

Government

Revenue

Goods & Services sold

Firms

Spending
Market for Goods and Services
(Goods Flow)

Investment

Goods & Services bought

Savings
Capital Market

Households

Inputs for production

Rent, wages, interest and

profit
Payments for imports

Market for Factors of Production

(Factor Flow)

Land, Labor, Capital and

Entrepreneur

Income
Export of man power
Foreign Sector

Receipts from exports

Foreign Remittance

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