Lecture 12 - Circular flow of income

1. Introduction

The circular flow of income is a fundamental economic model illustrating how money, goods, and services move through an economy. It depicts the interdependence of economic agents and how income is generated and distributed.

2. Key Economic Sectors

Economies are typically modeled with five main sectors:

  1. Households: Own factors of production (land, labor, capital, entrepreneurship) and consume goods and services.

  2. Firms: Produce goods and services, employ factors of production, and pay for them.

  3. Government: Imposes taxes, provides public goods and services, and engages in transfer payments.

  4. Financial Market: Facilitates saving and investment by channeling funds between savers (typically households) and borrowers (typically firms and government).

  5. Foreign Sector (Rest of the World): Engages in international trade (exports and imports) and capital flows.

3. Types of Flows

There are two main types of flows:

  • Real Flows: The flow of goods and services and factors of production.

    • Households provide factors of production to firms.

    • Firms provide goods and services to households.

  • Money Flows: The flow of payments for goods, services, and factors of production.

    • Firms pay households for factors of production (wages, rent, interest, profit).

    • Households pay firms for goods and services (consumption expenditure).

4. Models of the Circular Flow

4.1. Two-Sector Model (Households and Firms)

This is the simplest model, representing a closed economy without government or financial markets.

  • Households supply factors of production to Firms.

  • Firms use these factors to produce goods and services, which they sell to Households.

  • Firms pay Households for their factor services (income).

  • Households use this income to purchase goods and services from Firms (expenditure).

  • Gross Domestic Product (GDP) is equal to total income and total expenditure in this model.

    • GDP = C (where C is consumption expenditure)

4.2. Three-Sector Model (Adding Government)

This model introduces the Government sector.

  • Injections:

    • Government spending (G): Government purchases goods and services from firms and pays wages to government employees.

  • Leakages:

    • Taxes (T): Households and firms pay taxes to the government.

  • The government uses tax revenue to finance its spending and transfer payments.

  • GDP = C + G (assuming injections equal leakages)

4.3. Four-Sector Model (Adding Financial Markets)

This model incorporates the Financial Market.

  • Injections:

    • Investment (I): Firms borrow from financial markets to invest in capital goods.

  • Leakages:

    • Savings (S): Households save a portion of their income in financial institutions.

  • Financial markets enable the flow of funds from savers to investors.

  • Equilibrium condition: S = I

  • GDP = C + I + G

4.4. Five-Sector Model (Adding Foreign Sector - Open Economy)

This is the most complete model, including the Foreign Sector.

  • Injections:

    • Exports (X): Foreigners purchase goods and services produced domestically.

  • Leakages:

    • Imports (M): Domestic residents purchase goods and services from foreign countries.

  • Equilibrium condition for the full model: S + T + M = I + G + X

  • GDP = C + I + G + (X - M)

5. Injections and Leakages

  • Injections are additions to the circular flow that increase the total flow of income (e.g., investment, government spending, exports).

  • Leakages are withdrawals from the circular flow (e.g., savings, taxes, imports).

  • In equilibrium, total injections must equal total leakages.

6. Importance

Understanding the circular flow of income helps economists:

  • Measure national income (GDP).

  • Analyze economic relationships between sectors.

  • Identify causes of economic fluctuations.

  • Formulate macroeconomic policies (fiscal and monetary).