The Circular Flow of Income and Expenditure

1.2      The circular Flow of Income and Expenditure

Circular flow refers to a simple economic model which describes the reciprocal circulation of income between producers and consumers. In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households. In macroeconomics, we have the economy 2 sectors, 3 sectors and 4 sectors.

a.                   Economy 2 sector s  :           household and firm

b.                  Economy 3 sectors   :           household, firm and government

c.                   Economy 4 sector s   :           household, firm, government and international trade.

Terms in circular flow

·                     Household Sector

This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for consumption expenditures. It also owns all productive resources.

·                     Business Sector (Firm)

This includes the institutions (especially proprietorships, partnerships, and corporations) that undertake the task of combining resources to produce goods and services. This sector does the production. It also buys capital goods with investment expenditures.

·                     Government sector

This includes the ruling bodies of the federal, state, and local governments. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntary. It buys a portion of gross domestic product as government purchases.

·                     Product markets

This is the combination of all markets in the economy that exchange final goods and services. It is the mechanism that exchanges gross domestic product. The full name is aggregate product markets, which is also shortened to the aggregate market.

·                     Resource markets:

This is the combination of all markets that exchange the services of the economy's resources, or factors of production--including, labor, capital, land, and entrepreneurship. Another name for this is factor markets.

·                     Financial Markets:

The commodity exchanged through financial markets is legal claims. Legal claims represent ownership of physical assets (capital and other goods). Because the exchange of legal claims involves the counter flow of income, those seeking to save income buy legal claims and those wanting to borrow income sell legal claims.

1.2.1     Circular flow in 2 sectors economy

Two sectors economics consist of household and firm sectors. Foreign country and government sector does not exist.

 As such, in economic two sectors, circular flow is reflections on physical flow and cash flow between firm sectors and household sector. When household sector sell factors of production (labor, land, capital, and entrepreneur) to firm sector (Factor Flow), household sector received income in form of wage and salary, rent, interest, and profit (Income flow).

Most of the income will be spent (consumer) on goods and services provided by firm sector (market sector), and the rest will be deposited as fund at financial institutions (Fund Flow) as saving.

The fund available in financial institution will enable the investor to invest in product market.

            1.2.2   Circular flow in 3 sectors economy

Circular flow in 3 sectors economy refers to income flow and expenditure which occurred between economic sectors like household (C), firm (I) and government sector (G).

Household will receive income from the firm, namely salary and wage, rent, dividend and profit because household has offered factors of production to firm to generate goods and services.

 

Household would use that income to buy goods and services provided by the firm and this is called consumption spending. However, there’s small portion of the income will be deposited in financial institution and it is termed as leakages in income flow.

Financial institution will lend household savings to investors to invest in firm. Investment is injection in income flow.

Government will levy on household and firm. Households imposed personal income tax, while firm imposed corporate profitability tax. Tax is leakages in income flow and it acts as a source of government revenue. Government then uses its tax revenue through government expenditure which it’s distributed to household and firm. For example, government will pay wages to household that work as government employees.

Government on the other hand will build road, bridge, government school and hospital through investments which is done by firm. Government expenditure on firm and household is injection in income flow.

As such, in economic three sectors, according to aggregate supply equal aggregate expenditure, equilibrium of national income achieved when Y = C + I + G, while according to approach leakages equal injection, country's income balance achieved when S + T = I + G. 

1.2.3        Circular Flow in4 Sectors Economy

Circular flow in four sectors economy is similar to 3 sectors. In 4 sectors, we have  international trade as additional. Four sectors economy also called as open economy. It includes the term of trade like export and import.

Open economy refers to the existence of international trade in economy. It consists of four sectors; household sector, firm sector, government sector, and foreign sector. 

Injection in economy four sectors has the household (C), government expenditure (G), investment (I) and international trade (X-).