1. Circular Flow of Income
Chapter 2
Circular Flow of Income

2. Economic Activities Production
Process through which raw materials are converted into output using factors of production

3. Economic Activities Consumption
Process of utilisation of goods and services to satisfy human wants
Accounted for at the time of purchase of product, even though service may be provided over a period of time

4. Production = Consumption + Capital Formation
Economic Activities
Capital Formation
Excess of Production over Consumption
Also termed as investment
Improves the productive capacity of a nation
Production
Capital Formation
Consumption
Production = Consumption + Capital Formation

5. Changes in stock variables occur changes in flow variables
Stock vs Flow Variables
Flow Variables
Measured over a period of time
Eg:
Profit & loss of a company
Birth rates & death rates
Income of an individual
Stock Variables
Measured at a point in time
Eg:
Balance Sheet of a company
Population
Wealth of an individual
Changes in stock variables occur
due to
changes in flow variables

6. Sectors in an Economy Households Firms Owners of factors of production
Provide factor services to firms
Receive factor income in return
Spend income on goods and services (consumption)
Firms
Include both private and government owned
Hire factors of production to undertake production of goods and services
Sell output and generate income
Income paid to factors of production

7. Sectors in an Economy Government Rest of the World
Refers to the ‘general government’
Receives taxes from households and firms
Spends money on provision of services that improve welfare
Profit is not an objective
Rest of the World
External economy
Domestic economy undertakes transactions with the external economy
Imports – purchase of foreign products by domestic economy
Exports – sale of domestic products to external economy

8. Production (generation of income within a production unit)
Meaning of Circular Flow of Income
Production (generation of income within a production unit)

9. Meaning of Circular Flow of Income
Production (generation of income within a production unit)
Income (distribution of income to factors of production)

10. Meaning of Circular Flow of Income
Production (generation of income within a production unit)
Expenditure (disposal of income by households)
Income (distribution of income to factors of production)

11. Meaning of Circular Flow of Income
Production (generation of income within a production unit)
Expenditure (disposal of income by households)
Income (distribution of income to factors of production)

12. The Circular Flow of Income – 2 Sector Model
PRODUCT MARKET
Goods & Services
Payment for Goods & Services
Payment of factor income
Factor Services
FACTOR MARKET

13. The Circular Flow of Income – 2 Sector Model
PRODUCT MARKET
Goods and Services
Payment for goods & services
Payment of factor income
Factor Services
FACTOR MARKET
Money Flows
Represent the flow of money in the economy
Real Flows
Represent the flow of goods and services including factor services in the economy

14. Two Sector Model with Financial Sector
PRODUCT MARKET
Goods and Services
Payment for goods & services
Savings
Investment
FINANCIAL
SECTOR
(Leakage)
(Injection)
Payment of factor income
Factor Services
FACTOR MARKET
Savings : Residual income that households do not use to purchase goods and services
Investment : Expenditure on capital goods

15. Government purchases & subsidies
Financial Sector
Savings
(Leakage)
Investment
(Injection)
Goods and Services
Factor Services
Payment for goods & services
Payment of factor income
PRODUCT MARKET
FACTOR MARKET
Three Sector Model
Taxes
Taxes
(Leakage)
GOVERNMENT
Factor payments &
Transfer payments
Government purchases & subsidies
(Injection)
Equilibrium is achieved when leakages = injections
Savings + Taxes = Investment + Govt. Purchase + Payments

16. Four Sector Model Payment for Imports (Leakage) Payment for Imports
Rest of the
World
Factor Income (Injection)
Export Receipts (Injection)
PRODUCT MARKET
Goods and Services
Payment for goods & services
Savings
Financial
Sector
Investment
(Leakage)
(Injection)
Payment of factor income
Taxes
Taxes
Factor Services
FACTOR MARKET
(Leakage)
Government
Factor payments &
Transfer payments
Government purchases & subsidies
(Injection)
(Injection)
In Equilibrium : Leakages = Injections
Savings + Taxes + Imports = Investment + Govt. Expenditure & Transfers + Exports

17. Payment for goods and services
Circular Flow of Income - Summary
INJECTIONS
Export
expenditure (X)
Investment (I)
Government
expenditure (G)
Factor
payments
Financial
Sector
Payment for goods and services
Govt.
ROW
Import
expenditure (M)
Net
taxes (T)
Net
saving (S)
WITHDRAWALS