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    Circular Flow of Income

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    Circular Flow of Income

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    cowtirg eplli CIRCULAR FLOW OF INCOME LEARNING OBJECTIVES 1.1 INTRODUCTION 1.2 MEANING OF CIRCULAR FLOW OF INCOME 1.3 STOCK AND FLOW 1.4 TYPES OF CIRCULAR FLOW 1.5 CIRCULAR FLOW IN A SIMPLE ECONOMY (TWO-SECTOR ECONOMY) 1.1 INTRODUCTION The unlimited and recurring wants of human beings have made the production process, a continuous process. In this process, different factors of production: Land, Labour, Capital and Enterprise are combined together for production of goods and services. # Firms produce goods and services with collective efforts of factors of production supplied by the household sector « Firm makes payment to the factors of production in the form of rent, wages, interest and profit (known as factor incomes). «The household sector spends this money on the purchase of goods and services produced by the firms. from firms to households in the form of factor, expenditure. Such a flow of money. is, ae we 4.2 MEANING OF CIRCULAR FLOW OF INCOME refers to-cycle of generation of income in the production process, its distribution among ‘the factors of production and finally, its circulation from households to firms in the form ‘consumption expenditure on goods and services produced by them. : f introduc Pi, Generation Phase: In this phase, firms Produce goods and services with the help ; ‘of factor services. Prodan Pre: 19 (Gmrarnton trent} 2 Distribution Phase: This phase involves the / 7 flow of factor income (rent, wages, interest i and profit) from firms to the households, § ; 3. Disposition Phase: In this phase, the income j received by factors of production, is spent ‘on the goods and services produced by firms. j In this way, income generated in production units j reaches back to production units and makes the circular flow complete 1.3 STOCK AND FLOW ' The concepts of stock and flow are used frequently in macroeconomics. Some of the macro — variables relate to stock, while others relate to flow. Therefore, it is important to understand ‘their meaning so that variables can be categorised as stock or flow. J : i Stock Stock variable refers to that variable, which is measured at a particular point.af time For example. stock of goods in the godown as on 31" January, 2019. It means, stock variables aremat time dimensional. Some more examples of stock variables are National wealth, National capital, Money supply etc. Flow ‘Flow variable refers to that variable, which is measured over a period of time. For cameplt of goods during the month of January 2019, birth rate in the year 2018, National the year 2018 are flow variables. The ‘period of time’ could be a day, a week, FF flow variables are time dimensional as they are measured for a period of time: rae en Meaning | nae refers to that variable, iw measured at t Laduione, @ Particular point | which is measured | Itis a dynamic concept. 1. Population of India as on 31.03.18. | 1. Number of bi during 2. Total number of Maruti cars in Delhi. | 2. Man core mera : January, 2019. 3. Money supply (money in circulation). | 3. Expenditure or transactions money. ices 4. National Wealth. 4. National Income. ee 5. Quantity of wheat stored. 1.4 TYPES OF CIRCULAR FLOW There are two types of circular flows: (i) Real flow; (ii) Money Flow. Real Flow Real flow refers to the flow of factor services from households to firms and the corresponding flow of goods and services from firms to households. ‘Assen in the diagram, households provide factor services 5. Quantity of wheat produced. Factor Services to the firms which, in turn, provide goods and services to ian, —— a them as a reward for their productive services. a 5 ao * Itis also known as ‘Physical flow’. + ‘+ There is only exchange of goods and services between Goods and Services the two sectors without involvement of any money. Fig. 1.2 * Real flow determines the magnitude of growth process in an economy: For example, when more factor services are offered to firms, then volume of production will be more and it speeds up the process of economic growth. Money Flow Money Flow refers to flow of factor payments from firms to households for their factor services and corresponding flow tion expenditure from households to firms for M4 Introductory Mac oe i ote a Money 7 of goods and services Itis the flow of money between! between firms and households and households, “< It involves exchange of goods and It involves exchange | wolves of money, >] evo ives exchange of money, There may be difficulties of barter system | There ie No such difficulty in case | sulty in in exchange of goods and factor services. | of money flow. e Itis also known as Physical Flow. T Itis also known as Nominal Flow. | Four Sectors of the Economy The four major sectors in an economy according to the macroeconomic point of view are: 1. Household Sector: It includes consumers of goods and services and also the owners of factors of production. They supply factors like land, labour, capital and entrepreneur and Teceive income in return in the form of rent, wages, interest and profit respectively. 2. Producing Sector (Firms): It includes all producing firms in the economy. To produce goods and services, the firm hires factors of production from the households. Households consume goods and services to satisfy their wants and firms produce goods and services to make a profit. 3. Government Sector: It acts in two capacities: + Asa welfare agency, it is involved in maintaining law and order, defence and other services of public welfare. + Asa producer, it produces goods and services in public sector enterprises. 4. Foreign Sector (or External Sector or Rest of the World Sector): This sector includes transactions with the rest of the world. It is involved in export and import of goods and flow of capital between the domestic economy and other countries of the world. 5 CIRCULAR FLOW IN A SIMPLE ECONOMY (TWO-SECTOR ECONOMY) __ A simple economy assumes the existence of only two sectors, i.e. household sector and firm are the owners of factors of production and consumers of goods and services. i eholds. Firms produce goods and services and sell them to the hous’ form of closed economy, in which there is no government sector and foreign Chreuiar Flow of income 1. There are only 2 sectors in the economy: Housel government and foreign sector Household sector supplies factor services only to firms and the firms hire factor n vices only from households. 3. Firms produce goods and services and sell their entire output to the households. Households receive factor income for their services and spend the entire amount on consumption of goods and services. - Households 5, There are no savings in the economy, ie. neither the households save from their incomes, nor the firms save from their profits. Fig. 14 The Circular flow in Two-Sector economy can be better understood with the help of Fig. 14 * The outer loop of diagram shows the real flow, i. flow of factor services from households to firms and corresponding flow of goods and services from firms to households. « Theinner oop shows the money flow, ie. flow of factor payments from firms to households and the corresponding flow of consumption expenditure from households to firms. ‘money, which | isa In the circular flow of income, production generates factor income, which is converted into ‘expenditure. This flow of income continues as production isa continuous activity due to newer ending human wants. It makes the flow of income circular. Conclusions of Circular Flow in a Simple Economy Ina Two-Sector Economy, the following Conclusions can i goods and services by Firms = be drawn: ‘Total Consumption of goods and 2 BASIC CONCEPTS OF MACROECONOMICS LEARNING OBJECTIVES DOMESTIC TERRITORY (ECONOMIC TERRITORY) NORMAL RESIDENTS 2.3 FACTOR INCOME AND TRANSFER INCOME 2.4 FINAL GOODS AND INTERMEDIATE GOODS 2.5 CONSUMPTION GOODS AND CAPITAL GOODS | 2.6 GROSS INVESTMENT, NET INVESTMENT AND DEPRECIATION | 2.7 NET INDIRECT TAX (NIT) NET FACTOR INCOME FROM ABROAD (NFIA) 2.1 DOMESTIC TERRITORY (ECONOMIC TERRITORY) __ Domestic territory is a very important concept in national income accounting. In layman’s language, domestic territory means the political frontiers of a country. However, for the purpose of national income accounting, it is used in a wider sense. In addition to political frontiers, domestic territory also includes 1. Ships and aircrafts owned and operated by normal residents between two or more countries. For example, planes operated by Air India between Russia and Japan are part of the domestic territory of India. Similarly, planes operated by Singapore Airways between India and Japan are a part of the domestic territory of Singapore. : 2. Fishing vessels, oil and natural gas rigs and floating platforms operated by the residents of a country in the international waters where they have exclusive rights of ae For example, Fishing boats operated by Indian fishermen in intemational ‘waters of Indian Ocean will be considered a part of domestic territory of India. ek vs 3, Embassies, consulates and military establishments of a country located abroad. nd in Russi if the domestic teritory of India. ‘example, Indian Embassy in Russia is a part 2. International Organisations like UNO, WHO, etc locate, ‘d withi e boundaries of a country nn We B0grap | According to the United Nations, Economic Teritory or domestic teritory ie tp ‘by a government within which, Person's, goods and capital circulate Which of the following are covered under the An Indian Company in London, Microsoft Otfice in India, ‘Company in india owned by a Japanese, Office of Reliance industries in New York Branch of Foreign Bank in India. Indian Embassy in Japan, Branch of State Bank of India in China. Russian Embassy in india. Tata rented its building to Google in America, 'e domestic territory of india’? PPNOMRenwa 2.2 NORMAL RESIDENTS ‘Centre of Economic Interest’ implies two things: 1. The resident lives or is located within the Domestic Territory; and 2. The resident carries out basic economic activities of earnings, spending and accumulation from that location Following are not included under the category of Normal residents: 1. Foreign tourists and visitors who visit a country for recreation, holidays, medical treatment, study, sports, conferences, etc. 2. Foreign staff of Embassies, officials, diplomats and members of the armed forces of @ foreign country, located in the given country, A, d 3, International organisations like UNO, WHO, etc. are not considered as normal residents the country in which they operate. They are treated as the normal residents of international area. y ational organisations are considered as residents of the countries t ¢ é cae he genes Heh con area, or ewmpl an American working it located in India will be treated as normal resident of America. der workers who live near ountr here they Ii : regular ba: is to nal border and untry. Th . and not wh rere th \ey work Identity tho Yotowing aah Indian official af A Japonea nal Residents ofinam inthe indian Er tourist who stays ‘ as aNS going to Pakist ‘ ndians working Inthe Indian employeos Foreign tours vi working assy in USA inindlafor2 mont an for watching the crck UNO offic, located in Amora working in WHO, located in india siting Inia for | Indian Muslims going forthe for less than 1 year a month ose the Tj Mal Haj pilgrimage, E E Resident Jentship are two different ter Citizenship Itis basically a legal co ased on the place of birth of the person or some legal pr ng me a citizen. It means, Indian citizenship can arise in two wa hen a person is born in India, he acquires automatic citizenship of India | allowing a person to beco! | A person born outside India applies for citizenship and Indian Law all becom Indian Citizen “li Residentship « It is an economic concept based on the basi economic activities perform « An individual is a normal resident of a country if he ordin: period more than one year and his centre of economic interest al Example: A Chinese living in india for more than one year is a normal resident of india. However, Ne isnota citizen (or national) of india as he does not hold citizenship of india. Similarly, a Non-Resiient indian (NFI) is a citizen of India, but a resident of the country in which he lives. It means, a person ‘can be a citizen of one country and at the same time, a resident of another country. Wao ra ————————-—) The concepts of Domestic Territory and Normal Resident help to estimate ‘Domestic Product | and ‘National Product’ a ; Product’. Domestic Product 4. The concept of Domestic territory helps to ‘estimate ‘Domestic includes production ‘activity of production units oo 1 om sconomle tertory the residen resident means irrespective of fact whether carried out by plehonneet Foreign Nationals (ike final goods and services produced y For A gat tty ana willbe added to get aan Dicarkrapiersins ha distinguishing between nationals and The money value of domestic product is termed as Domestic Income. 23 Factor INCOME AND TRANS : FER INCOME : Factor tne: a Factor income refers to income received by factors of production* for rendering factor service in the production process, a * Itis received for providing factor services of land, | Income is earned for contributing to production pr * Factor income of normal residents of a country is * Rent, wages, interest and profit. labour, capital and enterprise. As factor | ‘ocess, it is a Bilateral Income. included in the National Income. * Itshould be noted that Factor Incomes and Factor Payments are the two sides of the same , ‘Coin. It is factor income from the viewpoint of the owners of factors of Production, while itis factor payment from the viewpoint of the producers of goods and services wat Lan a) oa nem) income refers to income received without rendering any productive service in retum. * Itis a unilateral (one-sided) concept. It is not included in National Income as it does not reflect any production of goods and services Itcan be received either within the domestic territory of a country or from abroad. E Old age pension, scholarship, unemployment allowance, pocket money, ete : F { Current } u a| J ——_——. ‘Transfer receipts are of two types: (i) Current Transfer; (ll) Capital Transfer. 1. Current transters are made out of income, whereas, capital transfers are made out of the Basic Concepts of Macroeconomics ee PO oe is included in both N |___hanster ines Nature. 25 ‘ational {1 = iis and t estic Income Income included in Ne Concept itis an earning conc eave eth i = c Is an earning concept i recip coneae= at receipt concept pi i s peesires by factors of production {itis generally received | el os Capital and enterprise). | households and govern ent \ Examy ‘ent, Wages, interest and Profit. | Scholarst . fit. ‘Scholarship, Old age pension, Unemployment allowance, etc, 2.4 FINAL GOODS AND INTERMEDIATE GOODS reveal All things that satisfy human wants are call d goods i i wants led goods. On the basis of mainly classified into two heads: (i) Final Conds; and (i) lmesmedlaie Goctgel am Goods; and (ii) Intermediate Goods. Final Goods Final goods refer to those goods which are used either for consumption or for investment. Final Goods Include: (i) Goods purchased by consumer households as they are meant for final consumption (like milk purchased by households), (ii) Goods purchased by firms for capital formation or investment (like machinery purchased by a firm). ; ; ods purchased by households is called ‘Consumption Expenditure’ an aarere tare on nal Gods purchased bythe producers calle Tvestment Expenditure 50, Expenditure on Final Goods = Consumption Expenditure + Investment Expenditure. transformation in the “it must be noted that final goods are neither reso nor used fr any lier aie "process of production. Intermediate Goods Intermediate goods refer to in the same year. Intermediate Goods include: : -sinenntinel i 1 resale (like milk purchase oP came seal production (like milk used for making, sweets) (ii) Goods us those goods which are used either for resale o for further production iate Goods " juction unit, Le. Important Points about pene one production unit from another prod + They are generally in the production boundary. diate goods remain wit * They have ‘p, ‘s he ed L as their de =croeconam, * They a manel depends on demand for fir _ Belermeticg et end for 1 their final user a ate goods. For ex p ‘ ~— example, Sugar purchased by a sweet sh . @ Value is to be added to sugar for making wert ay —— , urable like trucks, aircrafts, vehicles, ete.) purcha ° defense services and not for market sale ae d xa slits alee miller buys wheat worth 2 a nL hee a ns heat worth & 700 and converts it into flour worth ® 1,000. Now 1 i lur (Binal good) includes the value of wheat (intermediate good) , Production Boundar - The concept of production boundary is very a Significant to understand the d on derstand the difference coal Between intermediate and final goods. The [——— production boundary is the line around the Cotton worth ¢ 2.050 productive sector s goods remain | |_—andSetsirios | ‘ roduct ndary, they are —_¥__ " 3 produces Threa P and when a good com worth @ 8,000 an Inthe given diagram, there are 3 productior : units (A, Band C). The thick border drawn} | Sort °¢4 LL Consus around these three units is the Production _ | LS2!!8itto Consumers a Boundary. Within this limit, cotton and _ PRODUCTION BOUNDARY thread are intermediate goods. Cloth is a final good as it lies outside the purview of production boundary How to Classify Goods as: Intermediate Goods and Final Goods ted The distinction between intermediate goods and final goods is made on the basis of the use LP product and not on the basis of product itself. A commodity can be ar good as we tt a final good, depending upon its nature of use =< ft For Example: ba. (i) Sugar isan intermediate good when it is used by sweet shop for making sweets. Howeve ft if it is used by the consumers, then it becomes a final good. Ss (ii) Similarly, milk is an intermediate good when itis used in dairy shops for resale, However ol it becomes a final good when it is used by the households. mi 6.0 is made on the basis of end use. if end use of a good 6 fe t must be noted or then it is a final good. However, if the good is used for resale or further 2.0 the same year), then itis an intermediate good. i Example: Out of wheat jready inc Mat and flour, ony four (inal (arondy inchudee the valve of wheat (termediate poco) nt” Natoma mediate good) me a r more than one year a ; ‘xample: Suppose ee re pp ; X Ltd. purchases 10 tonnes coal in 2018 for mak ‘ was used up in 2018. Now, @8 coal in 2018 for making glasses tonnes co used up in 2018. Now. 7 tongs coal willbe taken a inormedate goods v odbadmaa Intermediate Good Final Goods Meaning —_| Final goods refer to those goods which are used either for consumption or for investment further product Nature | They are included in both national and | They are neither included in national | domestic income. income nor in domestic income. Value They are ready for use by their final | They are addition users i.e. no value has to be added to | value mediate the final goods. Production | They have crossed the production | They are stil within the Production | boundary. Boundary _ | boundary. Example | Milk purch consumption, © investment ged by households for | Mik use as an | used in fa ‘ar purchase ma categorised as Intermediate Products and Final Prod 1. Paper purchased by a publisher ee th isn intermediate product as paper is used Of AIS" “ 2. Furniture purchased by @ pened " i scause it purchased for inves {nis a final product 0 3. Milk purchased by hou tris a final product as it '8 4, Purchase of rice by @ These are intermediate products 5. Coal used by manufacturing FMS ing produ itis an intermediate product as cas ©. Computers installed in an OMI68. imagiment it 16 a final product because It's Pe! oy kts tor final cansumpno” seholds. ised by households eee a purchased for resale CBSE, Deir 8 Posner bya eos dealer, 80 these are purchased for resale of pulses bya a 0. Cran Presta Goaen ‘S used by a consumer for fina. Suustors, mare, st. echalke it. ‘consumption Purchased by a school, Dats He Products because these are taken to be used up completly curing a Pes. Pa ey by the farmers, = termediate Products because fertilizer is used for further production during | 12. Printer purcha hased by a lawyer, a Its a final produc # Because it is purchased for investment 13, Wheat usea by the flour mill, He product as wheat is used for further production dui 14, ikecte Coal with trader at year end. Itis a final product as the unsold coal is an i 18. Cotton used by a cloth mill, Itis an intermediate product as cotton is used for further production during the same year. 16. Wheat used by households. [t18 a final product as it is used by households for final consumption 17. Refrigerator installed by a firm. {t's a final product because it is purchased for investment. 18. Sugar used by a sweet shop. itis an intermediate product as sugar is used for further production uring the same year. 2.5 CONSUMPTION GOODS AND CAPITAL Goops ee Final goods can be classified into two groups: Consumption Goods and Capital Goods. Classification of Final Goods (tes Consumption Goods Consumption goods refer to those goods which satisfy the wants of the consumers directly ! For ewmple, Bread, butter, shirts, pens, television, furniture, ec goods can further be sub-divided into following dengan aan 1. Durable goods: It refers to those goods a br be —_ again and again over a period 01 vlc, television, refrigerators, et = Eee aes ee which can be used for a limited period of time are

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