CIRCULAR FLOW OF ECONOMY

Circular Flow of Income Simple Economy

The economy consists of two sectors: households and firms. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S). All output (O) produced by firms is purchased by households through their expenditure (E). There is no financial sector. There is no government sector. There is no overseas sector. Y = AD Y=C

Two Sector Model

In the simple two sector circular flow of income model (the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is: Y = E = O. Productive Sector (Firms) Household Sector

Two Sector Model without Savings

Flow In Physical Terms Household- Supply Factors of Production Firms- Supply goods & Services Flow in Monetary Terms Households- Consumption Expenditure Firms- Factor Incomes As the households spend all their income on consumption of goods and services, total money receipts of the firms will be the same as the total income of households.

Three Sector Model

1. 2. 3. Household Sector Productive Sector Financial Sector The part of Income which is not consumed is called Saving. S=Y-C Investment refers to expenditure on goods which are not consumed directly, but help in the production process. While savings are done by the households, investments are undertaken by the firms. Therefore, Savings and Investment in an economy need not be equal. S > I , The income flow declines I > S, The income flow increases

Four Sector Model

1. 2. 3. 4. Household Sector Productive Sector Financial Sector Government Sector Government revenue from taxes- (T) Personal taxes & Corporate taxes Government expenditure on- (G) Administration, Justice, Public utilities, Defence T < G, Budget Deficit >>>Flow of income Increases T > G, Budget Surplus >>>Flow of Income decreases

Five Sector Model (Open Economy)

1. 2. 3. 4. 5. Household Sector Productive Sector Financial Sector Government Sector External Sector

Countrys Expenditure on Imports (M) Countrys Revenue from Exports (X) Import > Exports >>>Unfavorable Balance of Trade- Flow of income decreases Imports < Exports >>> Surplus on Balance of Trade- Flow of income increases

Five Sector Circular Flow of Income

Income

Resources

Households
Output
Expenditure Savings Taxation Financial Sector

Firms

Investment Govt. Spending

Govt. Sector

Imports

External Sector

Exports

Leakages and Injections in five sector model

LEAKAGES Saving (S) Taxes (T) Imports (M) INJECTIONS Investment (I) Government Spending (G) Exports (X)

State of Equilibrium
In terms of the five sector circular flow of income model the state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy. This can be shown as: Savings + Taxes + Imports = Investment + Government Spending + Exports S + T + M = I + G + X.

If injections exceed leakages, the circular flow grows (i.e., there is economic prosperity), while if they are less than leakages, the circular flow shrinks (i.e., there is a recession).