What is Circular Flow of Income ?
- The circular flow of income is an economic model which is designed to show how money and goods and services move between sectors in an economic system.
- The circular flow of income describes how money and economic resources flow in cycle between different sectors in an economic system.
- National income is a flow concept. A large number of goods and services are produced in an economy every year. These goods and services are produced in the production units by combining different factors of production. These factors of production are purchased by the producers from the owners of these factors of production, which generate income for the owners. The income generated are spent on the purchase of goods from the production units. This expenditure generate income for the producers. This way in an economy, goods and services and factor services are being constantly exchanged between different individuals like producers and households.
- This flow of goods and services and factor services among producer, households and other individuals in an economy is known as circular flow of income.
- “Circular flow of income is defined as the flow of payments and receipts for goods and services and factor services between different sectors of economy”.
- The flow of national income is constant and circular in nature. It can be said that there is a constant flow of income and expenditure among different sectors of economy.
- Incomes are generated in production units in the process of production.
- Then the income flows from production units in the form of factor payments to households and then from households to production units in the form of expenditure on goods and services produced by the production units. This way income flows in a circular way among different sectors of economy.
- Goods and services flow in one direction and money payments to acquire these goods and services flow in opposite direction thereby leading to a circular flow.
- It is called circular because it goes on continuously and indefinitely in a circular way, it has neither any specific beginning nor any end.
- In an economy, the economic transactions like sale and purchase of goods and services generate two types of flows – Real flow and Money flow.
- Real flow – “Real flow consists of flow of factor services and flow of goods and services among different sectors of an economy.” Real flow involves two kinds of flow – the flow of factors of production such as land and labour from their owners to the producers and the flow of goods and services from firms to the buyers of these goods and services.
- The Money flow – The money flows consist of flow of money incomes for factor services such as money wages, rent, interest etc. and money expenditure incurred on the purchase of goods and services. In the economy, the flow of factor services generates factor income in the form of money. Buyers of goods and services make payment for goods and services purchased with money. This transfer of money is called money flow.
- The real flow of goods and services is matched by an equal but reverse money flow.
- National income is both a flow of goods and services and flow of money incomes.
- Economic sectors of economy – There are four sectors of economy – 1. Household sector 2. Business sector 3. Government sector 4. Foreign sector or rest of the world.
1. Household Sector:
- Households are the main owners of factors of production – land, labour and capital.
- They sell their services of these factors to the producers and receive their income in return.
- They spend a large part of their income in purchasing goods and services from the producers.
- They save a part of their income and pay taxes to the government out of their income.
2. Business Sector:
- Business sector or producer or firm hire services of factors of production from households to produce commodities that they sell to households, other firms, government or to other countries.
- Firms are the principal buyers of factors of production and main producers of commodities.
- Business sector comprise of both private and government enterprises. But to keep our study simple we assume that business sector is only private.
3. Government Sector:
- For simplicity, government sector is taken as only general government and government commercial enterprises are excluded.
- Government gets its income largely through taxes imposed on households and business sectors in the form of direct and indirect taxes.
- It buys goods and services from the producers and factor services from the households.
- It uses these commodities and factor services in providing free services such as medical facilities, judicial services, police services education etc. to the people to satisfy their collective wants.
4. Foreign Sector / Rest of the World:
- A country exports goods and services to other countries and similarly it imports goods and services from other countries.
- Similarly, factor services move across the border of a country and the firms of this country may purchase some factor services from other countries.
Three Models of Circular Flow:
In order to study the circular flow in a simplified way, these four sectors combine to form three models:
1. Two Sector Model:
This model consist of households sector and business sector.
2. Three Sector Closed Economy Model:
This model comprising the household sector, business sector and government sector. Since there is no interaction with foreign or rest of the world this type of economy is called as closed economy.
3. Four Sector Open Economy Model:
This model consist of household sector, business sector, government sector and foreign sector or rest of the world. Since this type of economy is open to interact with other countries as well it is called open economy.