Circular Flow and Economic Activity

Dr. A.K. Dash

FOSS, IFHE University
 How an economy operates
 The economy operates as a complex system involving the
production, distribution, and consumption of goods and services
 Production: Firms produces goods and services using factors of
production such as land, labor, capital, and raw materials. This
process often involves technology and innovation to increase
efficiency.
 Distribution: Once goods and services are produced, they are
distributed through various channels to reach consumers. This
includes transportation, retail, and online sales.
 Consumption: Consumers purchase and use goods and services
based on their needs and preferences. Consumption drives
demand, which in turn influences production levels.
 Role of Money: Money serves as a medium of exchange, a unit of
account, and a store of value, facilitating transactions and
economic activity.
 Government's Role: Governments influence the economy
through fiscal policy (taxing and spending) and monetary policy
(controlling the money supply and interest rates). They may also
regulate industries to ensure fair competition and protect
consumers.
 Global Interactions: Economies are interconnected through
trade, investment, and finance
 Circular flow Model
The circular flow model demonstrates how money moves within an economy.
Money flows from producers to workers as wages and flows back to
producers as payment for products. The circular flow model shows how
money moves from producers to households and back again in an endless
loop. The circular flow model highlights the “flows” within the economy—
the flow of economic resources, goods and services, and the flow of money.
The circular flow model shows the interaction between two groups of
economic decision-makers—households and firms. A change in one sector
may critically change the rest of the circular flow model. The circular flow
model is used to measure a nation's income, as the circular flow model
measures both cash coming into and exiting a nation's economy.
The circular flow model helps us learn and understand how the economy
functions.
Economic transactions generate two types of flows (product and money flow)
1. Product flow is the flow of goods and services. It is also known as real flow.
2. Money flow. It is known as the flow of money. Money flows can be looked
upon from two angles
(i) Money flows as factor payments(rent , wage, interest) and
(ii) Money flows as payments for goods and services.
The Product flow and money flow operates in opposite direction in a circular flow model.
The entire economic system can be therefore be viewed as a circular flow of income
and expenditure
To present a circular flow of income and expenditure, the economy is divided into a
sector model, a three-sector model, a four-sector model and a five-sector model.
There are different types of circular flow models, each with a different number of
sectors it tracks.
Two sector model includes households (consumer unit) and firms (production unit).
 The households sector is defined as individuals or groups of individuals who
used to stay together and share a common kitchen. In a two-sector model, circular
flow models start with the household sector that engages in consumption
spending (C). Households contribute to an economy by working (giving away
time and labor) and by buying products (giving away money).
 A firm is an organization that produces goods or provides a service that people pay for
 Three sector model includes the household sector, firm(business sector), and
Government.
 Four sector model includes household, firm, government, and foreign sector.
 The fifth sector model includes households, firms, government, foreign sector, and
financial intermediaries.
Circular flow model of income and expenditure in a two sector Model
The two-sector model, which consists of household and firm represents a
closed economy. A closed economy means no exports, and no imports with no
government intervention.
Before we analyse the circular flow model, it is important to know the features
of the household and firm sectors.
Features of the Household Sector
(1) Households are the owners of all the factors of production. The factor of
production you know land, labour, capital, and entrepreneur.
(2) households provide the factor of production to the firm, and receives
factor income such as rent, wage, interest, and profit.
(3) Households are basically consumer units whose ultimate aim is to satisfy
their wants.
(4) Household sector spends its entire income on goods and services that are
produced by the firms. The household sector doesn’t save.
Features of the Firm/Business sector
 Firm own no resources of their own
 Firm hire/lease and use the factor of production such as land, labour,
capital from the household
 By using the factor of production, the firm produces and sells goods and
services to the household sector
 They don’t save: that is, there are no corporate savings
Note: The firm or business sector is known as production units, and the
household sector is treated as consumer units.
 Assumptions
 The economy is a closed economy (no foreign trade. I mean exports and
imports)
 Production takes place only by the firm sector
 Household spend their total income on goods and services produced by the
firms
 Firms produce goods and services only as much as demanded by the
household. They do not maintain inventory
 Firm makes factor payments to the household in the form of rent, wage,
interest and profit
 There is no inflow or outflow of income or goods and services from any
outside source
The Circular Flows in a Two Sector Model: A Graphical
Representation
The Circular Flows in a Two Sector Model: A Graphical Representation continues…
 Let’s start with the two groups of economic decision-makers. On one side of the
model are households. Households consist of one or more persons who live in the
same housing unit, such as a family. Households own all the economic resources in
the economy. The economic resources are land, labor, capital, and entrepreneurial
ability.
 Land resources are natural resources. For example, these could be actual land owned
by a farmer .
 Labor is just what it sounds like—work for which you are paid.
 Capital resources are goods used to produce other goods and services. For example,
think of a hammer used by a carpenter or a computer used at a business.
 Finally, entrepreneurial ability is the human resource that combines the other
resources to produce new goods and services and bring them to market. So, an
entrepreneur might combine land, labor, and capital in new ways—taking risks
along the way—to bring a good or service to market.
 Households receive wages for their labor, rent for use of their land, interest for use
of their capital, and profit for their entrepreneurial ability. households sell resources
and firm buy resources.
 On the other side we have firm. A firm is a privately owned organization that
produces goods and services and then sells them
The resources flow one way (counter-clockwise) and money flows the other (clockwise).
 The Circular Flows in a Two Sector Model Continues…
 A line is drawn from the household to the firm sector which divides
diagram into two parts- the upper half and the lower half. The upper
half represents the factor market and the lower half represents the
commodity markets. Both the markets create two kinds of flow-real
flows and money flows.
 In the factor market (the upper half) the arrow labelled the flow of
factor of production from the households to the firms. The flow of
factor incomes (rent, wages, interest and profits) from the firms to
the households. Since all the factor payments are made in terms of
money, the flow of factor income represents the money flow.
 In the commodity market(the lower half) the goods and services
produced by the firms flow from the firm to the household. The
payment made by the households for the goods and services creates
money flow.
Circular Flow Model of Income and Expenditure in a
Three Sector Model
Circular Flow Model of Income and Expenditure in a
Three Sector Model Continues….
The government injects money into the circle through government spending (G) on
programs such as Social Security. It also extracts money from households and
businesses by way of [Link] three-sector model represents money flow to and
from the government and excludes the flow of goods to and from the government
in order to avoid over crowding to the diagram.

Note: Three sector model is the combination of the sector model +Government

Let’s see the linkage between households and the government.

The household sector provides manpower, direct tax(income tax) and indirect tax(GST) to
the government and the Government provides wages, salary, unemployment allowances,
pensions, subsidies, and transfer payments to the household sector.
Let’s see the linkage between the Firm and the government
The firms used to give direct tax (corporate tax) and indirect tax(excise duty by selling
alcohol, tobacco etc) to the government. On the other hand, the government purchases
goods and services from the firm and provides subsidy (tax subsidy) to the firm. In
addition, the government also provides infrastructure to the firms such as roads, water
connections etc.
What do you mean by Transfer Payments
Transfer payments are the payments made by people to the people, and by
people to the government without corresponding transfer of goods and
services. In other words, transfer payments refers to the flow of money
without a reverse flow of goods and services. For example, when a person gift
some money to a relative or friend, or to a poor person or a charitable
organization, without receiving anything in return, it is a transfer payments.
Gift to Red Cross Society
 Unemployment allowances
 Scholarship
 Money received from a relative working in a foreign country
 Old age pension
 When a father pays some money to their children
Subsidy
A subsidy is a benefit given to an individual, business, or institution, usually
by the government. It is usually in the form of a cash payment or
a tax reduction. The subsidy is typically given to remove some type of burden,
and it is often considered to be in the overall interest of the public.
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Note: Four sector model is the combination of three sector model +foreign sector
You have a clear idea about the household sector, Firm sector, and Government sector. Now, we will
include the foreign sector . Foreign Sector: This includes all economic transactions with other countries, such as
exports and imports, foreign investments, and financial flows.
The linkage between Household and Foreign Sector
The household sector provides factor inputs such as skilled and unskilled labour to the foreign(external
sector). The foreign sector makes factor payments for the factor inputs. The household sector can invest in
the foreign sector such as buying stock, bonds, houses etc. The household sector buys goods from the
foreign sector too.
The linkage between Firm and Foreign Sector
The firm exports goods and services to the foreign sector and imports goods and services from the foreign
sector. While exporting goods and services to the foreign sector, firms receive money while exporting and
make payments to the foreign sector while importing.
Likewise, the foreign sector exports goods and services to the firms and imports goods and services from
the firms. The foreign sector can invest in firms in the form of foreign direct investment(FDI) and Foreign
portfolio investment (FPI)
The Linkage between Government and Foreign Sector
Like firms, the government also exports goods and services to the foreign sector. The government also
imports goods and services from the foreign sector. Similarly, the foreign sector, exports goods, and
services to the government, and the foreign sector imports goods and services from the government. The
government also invest in foreign sector and the foreign sector can invest in the Government.
The government lends to and borrows money from the foreign sector. Likewise, the foreign sector lends to
and borrows money from the government.
Circular Flow Model of Income and Expenditure in a Four
Sector Model Continues…
Circular flow model of income and expenditure in a
five sector Model
Note: Five sector model is the combination of four sector
model +financial sector(Financial intermediaries)
Financial Intermediaries Defn.
 Financial intermediaries are institutions that facilitate the flow of funds
between savers and borrowers in the economy. They play a crucial role in
the financial system by channeling funds from those who have surplus
capital (such as individuals or businesses with savings) to those who need
capital (such as individuals or businesses seeking loans). Financial
intermediaries moves funds from parties with excess capital to the parties
needing funds. A financial intermediaries is an institution or individual
who serves as a middle men among the diverse parties to facilitate
financial transactions. It acts as middle men between two parties in a
financial transactions.
 Key types of financial intermediaries include:
1. Banks: Accept deposits and provide loans.
2. Investment Funds: Pool money from multiple investors to invest in
securities or other assets
3. Pension Funds: Manage retirement savings and invest on behalf of
members.
Examples of financial intermediaries are commercial banks,
Circular flow model of income and expenditure in a five
sector Model Continues..

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Note: Government and financial intermediaries linkage: Government

borrows money from financial intermediaries. Government supports
the financial intermediaries when they are in trouble. Financial
intermediaries borrows money from foreign sector and lends money
to foreign sector.
Circular flow model of income and expenditure in a five
sector Model continues…
Linkage between household sector and Financial Intermediaries
Household sector is known as lender or depositor of money. Household sector
used to deposit their excess money in the commercial banks. The financial
intermediaries(banks) pay some interest to the households for their deposits.
Linkage between Firm sector and Financial Intermediaries
You know that firms used to invest heavily. In order to do so, firms borrow
money(takes loans) from the financial intermediaries. Do you think it is free
cost cost?. Financial intermediaries charge high interest rate to the firm for
borrowings.
Pls Note: When household sector deposits their excess money in the financial
intermediaries, financial intermediaries used to pay low interest rate to
household sector. On the other hand, when firms borrows money from the
financial intermediaries, financial intermediaries charges higher interest rate
for firm. Here, financial intermediaries act as a middleman (in-between
household and firms). It accepts deposits from the household sector and pay
low interest rate and lends money to the firm and charges higher interest rate.
This is the way financial intermediaries makes profit.
Circular Flow Model: Injections and Leakages
Just as money is injected into the economy, money is withdrawn or
leaked through various means as well.
Leakages in the Circular flow model
Leakages- In economics, leakage refers to capital or income
that diverges from some kind of iterative system. Leakages
refer to the outflow of money in the circular flow model. It
reduce the overall level of economic activity. For ex. Taxes,
imports, Savings.
Taxes-Taxes are imposed by the government which reduces the
flow of income of households and the firm which could otherwise
be spent or invested.
Imports- When consumers purchase goods and services from abroad,
the money spent on these imports exits the domestic economy,
leading to a reduction in demand for locally produced goods.
 Savings (S)- Savings are the part of the disposable income which are not consumed but
saved. When households save a portion of their income rather than spending it, this money is
not circulating in the economy, leading to potential reductions in consumption and
investment.
Injection in Circular flow Model
In economics, "injections" refer to the flows of money into the circular flow of
income in an economy, which can stimulate overall economic activity. Injections can help
counteract the effects of leakages. . It includes investment, Government spending, and
exports.
 Investment: Expenditures by businesses on capital goods, such as machinery and
buildings, which increase production capacity and create jobs.
 Government spending: Money spent by the government on public services
such as infrastructure and welfare program which boosts demand and
stimulate economic activity. The government injects money into the circular
flow model by providing subsidies to households and firms, and through
other social welfare schemes
 Exports: Income generated from selling goods and services to foreign markets.
This money flows into the domestic economy and increases demand for local
production.
Injections are crucial for maintaining economic growth and stability, as they
help offset the impact of leakages (such as savings, taxes, and imports) by
ensuring that money continues to circulate within the economy .
 The circular flow of income for a nation is said to be balanced when
withdrawals are equal injections
 The level of injections is the sum of government spending (G), exports (X)
and investments (I).
 The level of leakage or withdrawals is the sum of taxation (T), imports (M)
and savings (S).
When G + X + I is greater than T + M + S, the level of national income will
increase.
When the total leakage is greater than the total injected into the circular flow,
national income will decrease.
As long as a country's injections is greater than its leakages, a country's
economy can theoretically remain sustaining forever.
Thank you