Chapter 02: Circular Flow of Income and Expenditure

1. Learning Outcomes:
After studying this module, you shall be able to
• Know the four macroeconomic sectors and the three markets.
• Learn the interdependence among the sectors and the markets.
• Identify the different models of the circular flow of income.
• Evaluate the leakages and injections in the circular flow.
• Analyse the significance of the circular flow of income in macroeconomics.
2. Introduction:
Macroeconomics is the branch of economics that studies the economic behaviour of all the agents in
the economy; i.e. it is the study of the economy as a whole. In other words, macroeconomics is the
study of aggregate outcomes of the decisions taken by the different agents in an economy.
To begin the study of basic macroeconomics, let us introduce the concept of the circular flow of
Income. The circular flow of income forms the basis for all the macroeconomic models of the
economy, and it is imperative to understand the circular flow model to understand essential concepts
like national income, aggregate demand, and aggregate supply.
The circular flow of income describes the movement of goods or services and income among the
different sectors of the economy. It illustrates the interdependence of the sectors and the markets to
facilitate both real and monetary flow.
The real flow refers to the flow of factor services and the flow of goods and services. The flow of
factor services from the households to the firms and the flow of goods and services from firms to the
households is the real flow. The flow of factor services generates money flows in the form of factor
payments, which the firms pay the household, and similarly, the household needs to pay the firms for
the flow of goods and services. The movement of the money/cash payment from one sector to the other
sector corresponding to the real flow is referred to as the monetary flow. Thus, the income of one
sector becomes the expenditure of the other, and the supply of goods and services by one sector
becomes the demand of the other sector. The real flow and monetary flow move in a circular manner
in an opposite direction. A continuous flow of production, income and expenditure is known as the
circular flow of income.
3. The Four Macroeconomic Sectors:
3.1 The Household Sector: This sector includes all the individuals in the economy. The primary
function of this sector is to provide the factors of production. The factors of production include land,
labour, capital and enterprise. The household sectors are the consumers who consume the goods and
services produced by the firms and, in return, make payments for the same.
3.2 The Firms Sector: This sector includes all the business entities, corporations and partnerships.
The primary function of this sector is to produce goods and services for sale in the market and make
factor payments to the household sector.
3.3 The Government Sector: This sector includes the centre, state, and local governments. The prime
function of this sector is to regulate the functioning of the economy. The government sector incurs
both revenue and expenditure. The government earns revenue from tax and non-tax sources and incurs
expenditures to provide essential public services to the people.
3.4 The Foreign Sector: This sector includes transactions with the rest of the world. Foreign trade
implies net exports (exports minus imports). Exports include goods and services produced
domestically and sold to the rest of the world, and imports include goods and services produced abroad
and sold domestically.
4. The Three Markets
4.1 The Goods Market: In this market, goods and services are exchanged among the four
macroeconomic sectors. The consumers are the household, government and the foreign sector, while
the producers are the firms.
4.2 The Factor Market: The factors of production are traded through this market. For the production
of final goods and services, the firms obtain the factor services and make payments in the form of rent,
wages, and profits for the services provided to the household sector.
4.3 The Financial Market: This market consists of financial institutions such as banks and non-bank
intermediaries who engage in borrowing (savings from households) and lending of money.
5. The Circular Flow of Income in a Two-Sector Model:
In this model, the economy is assumed to be a closed economy and consists of only two sectors, i.e.,
the household and the firms. A closed economy is an economy that does not participate in international
trade. In this model, the household sector is the only buyer of the goods and services produced by the
firms and it is also the only supplier of the factors of production. The household sector spends the
entire income on the purchase of goods and services produced by the firms, implying that there is no
saving or investment in the economy. The firms are the only producers of goods and services. The
firms generate income by selling the goods and services to the household sector and the latter earns
income by selling the factors of production to the former. Thus, the income of the producers is equal
to the income of the households and is equal to the consumption expenditure of the household. The
demand of the economy is equal to the supply. In this model, Y = C, where Y is Income and C is
Consumption. The circular flow of income in a two-sector model is explained with the help of the
following diagram, called Model 1.
5.1 The Circular Flow of Income in a Two-Sector Model with Saving and Investment:
In the above model, we assumed that the household sector spends its entire income and that there is no
saving in the economy; however, in practice, the household sector does not spend all its income; it
saves a part of it. Savings by the household sector would imply monetary withdrawal (equal to savings)
from the circular flow of income. This would affect the sale of the firms since the entire income of the
household would not reach the firm, implying that the production of goods and services would be more
than the sale. Consequently, the firms would decrease their production, which would lead to a fall in
household income. There is one way of equating the sales of the firms with the income generated; if
the savings of the household are credited to the firms for investment, then the income gap can be filled.
Suppose the total investment (I) of the firms is equal to the total saving (S) of the household sector. In
that case, the equilibrium level of the economy will be maintained at the original level. This is
explained with the help of the following diagram, called Model 1a. The equilibrium condition for a
two-sector model with saving and investment is as follows:
Y = C + S or Y = C + I or C + S = C + I
Or, S = I
Where, Y = Income, C = Consumption, S = Saving and I = Investment
6. The Circular Flow of Income in a Three-Sector Model:
The three-sector model of the circular flow of income highlights the role played by the government
sector. This is a more realistic model that includes the economic activities of the government; however,
we continue to assume the economy is closed. There are no transactions with the rest of the world. The
government levies taxes on households and firms, gives subsidies to firms, and transfers payments to
the household sector. Thus, there is income flow from the household and firms to the government via
taxes in one direction, and there is income outflow from the government to the household and firms in
the other direction. If the government revenue falls short of its expenditure, it is also known to borrow
through financial markets. This sector adds three key elements to the circular flow model, i.e., taxes,
government purchases and government borrowings. This is explained with the help of the following
diagram called Model 2.
In this model, the equilibrium condition is as follows:
Y=C+I+G
Where, Y = Income; C = Consumption; I = Investment and G = Government Expenditure
In a closed economy, aggregate demand is measured by adding consumption, investment and
government expenditure. Thus, aggregate demand is defined as the total demand for final goods and
services in an economy at a given time and price level and aggregate supply is defined as the total
supply of goods and services that the firms are willing to sell in an economy at a given price level.
7. The Circular Flow Of Income in a Four Sector Model:
This is the complete model of the circular flow of income that incorporates all four macroeconomic
sectors. Along with the above three sectors, it considers the effect of foreign trade on the circular flow.
With the inclusion of this sector, the economy has become an ‘open economy’. Foreign trade includes
two transactions, i.e., exports and imports. Goods and services are exported from one country to the
other countries, and imports come to a country from different countries in the goods market. There is
an inflow of income to the firms and government in the form of payments for the exports, and there is
an outflow of income when the firms and governments make payments abroad for the imports. The
import payments and export receipts transactions are done in the financial market. This is explained
with the help of the following diagram, called Model 3.
In this model, the equilibrium condition is as follows:
Y = C + I + G + NX
NX = Net Exports = Exports (X) – Imports (M)
Where Y = Income; C = Consumption, I = Investment, G = Government Expenditure, X = Exports
and M = Imports.
8. Leakages and Injections in the Circular Flow of Income
The flow of income in the circular flow model does not always remain constant. The volume of income
flow decreases due to the leakages of income in the circular flow, and similarly, it increases with the
injection of income into the circular flow.
Leakages: A leakage is referred to as an outflow of income from the circular flow model. Leakages
are part of the income that the household withdraws from the circular flow and are not used to purchase
goods and services. This part of the income does not go to the goods market. There are three main
leakages, and these are:
 Saving: It is that part of the income that is not used by the household to purchase goods and
services or pay taxes. It is kept with financial institutions like banks that can be lent further by
the banks to the firms for investment or capital expansion purposes.
 Taxes: Tax revenue is the income paid by the household and firms to the government. It flows
to the government rather than the goods market.
  Imports: Import payments are made to the foreign sector for the goods and services bought
from them. This is an outflow of income from the economy.
Thus, we see that leakages reduce the volume of income from the circular flow of income.
Leakages = S + T + M
Where, S = Saving; T = Taxes; and M = Imports
Injections: An injection is an inflow of income to the circular flow. The volume of income increases
due to an injection of income in the circular flow. There are three main injections, and these are:
 Investment: It is the total expenditure by the firms on capital expansion. It flows to the goods
market.
 Government Expenditure: It is the total expenditure of the government on goods and services,
subsidies to the firms and transfer payments to the household sector. Transfer payments are
government payments like social security schemes, pensions, retirement benefits, temporary
aid to needy families, etc.
 Exports: Export receipts are the payments made by the foreign sector for the purchase of
domestic goods. It is an inflow of income from the foreign sector to the financial market.
Injections = I + G + X
Where, I = Investment; G = Government Expenditure; and X = Exports
Balance of leakages and Injections in an open economy is S + T + M = I + G + X
Or, (S –I) = (G – T) + (X – M)
The leakages and injections can be shown in the following diagram called Model 4.
Model 4: The Leakages and Injections in the Circular Flow of Income

9. Summary:
 The circular flow of income describes the movement of goods or services and income among
the different sectors of the economy. It illustrates the interdependence of the sectors and the
markets to facilitate both real and monetary flow.
 The real flow refers to the flow of factor services and the flow of goods and services. The
movement of the money/cash payment from one sector to the other sector corresponding to the
real flow is referred to as the monetary flow.
 There are four sectors and three markets in the circular flow of income model. The four sectors
are the household sector, the firm sector, the government sector and the foreign sector. The
three markets are the goods market, the factor market, and the financial market.
 The circular flow of income can be analysed with the help of three different models, i.e.,
circular flow income in a two-sector model, in a three-sector model and a four-sector model.
 A two-sector model is the simplest model of the circular flow of income. It is assumed to be a
closed economy. There are only two sectors – the household sector and the firm sector. The
flow of income and expenditure is between these two sectors only.
 In a three-sector model, apart from the above two sectors, there is another sector called the
government sector. The economy is still closed, meaning that there is no transaction with the
rest of the world.
 A four-sector model is the complete model of the circular flow of income. It considers the
effect of the foreign sector, which includes transactions with the rest of the world. The economy
is now an open economy.
 The volume of income in the circular flow increases with the injections in the economy and
decreases with the leakages in the economy.
 Injections are inflows of income to the circular flow and leakages are outflows of income from
the circular flow.
 The Injections are mainly investment, government expenditure and exports, and leakages are
mostly savings, taxes and imports.