Circular Flow of Economic Activity

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Dr.Sarita Kumari

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Macro economics involves the study of the inter-relationship between various sectors and the determination of economic activity of these sectors. Money, goods and factor services flow through the economy in a circular manner. Business, government and households(3 major transactors) are interdependent. These groups help to create and maintain 6/7/12 Dr.Sarita a process that continues 22 economic activity in Kumari

Circular flow of income in a simple economy where all income is consumed

There are two sectors: household sector and productive sector. Money value of income of households must be equal the money value of output of firms. Money value of household expenditures to purchase this output provides the basis for national income accounting.
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Assumption: Household spends all the income.

Circular flow of income in a simple economy where all income is consumed cont
Wages & Profits (i.e. income) Rs. 1000 (Y)

1 2
Productive Sector

Household Sector

Private Consumption (Rs. 1000) 6/7/12

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Circular flow of income in a closed economy

An economy in which there is no foreign sector and no government intervention. Assumptions: Households either save (S) or spend on consumer goods and services (C) AD = C + S Firms produce goods and services for consumption (C ) and investment (I)

1.

2.

3. Saving Leakage from the national income flow, which can be counter-balanced by Investment expenditure, representing 6/7/12 Dr.Sarita Kumari 55 injection into the circular flow.

Circular flow of income in a closed economy cont

Equilibrium:

National income is in equilibrium as the value of leakages is matched by an equal value of injections. Saving Wages & Profits (S) = Investment(I) (i.e. income)
Rs. 1000 (Y) Productive Sector

Household Sector

Private Consumption (Rs. 800) 6/7/12 Dr.Sarita Kumari 66

Circular flow of income in a closed economy cont

In the economy Y = AD, therefore Y = C + I In equilibrium S = I If S>I, AD and income will fall and If S<I, AD and income will rise

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Circular flow of income in a closed economy with the presence of government sector

Leakages in the form of saving (S) and taxation (T) Injection of income arises in the form of expenditure and government spending. Equilibrium is attained S + T = I + G i.e. Leakage = Injection

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Circular flow of income in an open economy

An open economy is one in which foreign trade and international capital flows take place. There is also government spending and taxation. Households need not consume all of their income. A part is saved (S) spent on imports (M) and taxed (T) S + M + T = Withdrawal (W)/ Leakages. Income will be added to investment (I), government spending (G), and money spent by foreigners on export (X).
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I + X + G = Injection (J)

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Circular flow of income in an open economy cont

Wages & Profits (i.e. income) Rs. 1000 (Y) Household Sector

1 2
Productive Sector

4 3
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Private Consumption (Rs. 800)

Dr.Sarita Kumari

1010

Circular flow of income in an open economy cont

In the economy Y = AD Y=C+I+G+X Y=C+J Equilibrium is attained X S+M+T=I+G+ or W = J

If J>W, the level of national income will rise If J<W, the level of national income will fall

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Dr.Sarita Kumari

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Thank You

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Dr.Sarita Kumari

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