Circular Flow of Income Chapter 2 Circular Flow of Income

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

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

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

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

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

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

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

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

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)

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)

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

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

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

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

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

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