Circular Flow of Income and Expenditure: Introduction and Two Sector Model Analysis

Introduction

An economy is the integrated form of various activities like production, consumption, and exchange. All these activities are carried out by the transaction of goods and services among various entity of economy. The functioning of any economy can be represented in a circular diagram which is called circular flow of income and expenditure. The circular flow is defined as the flow of goods and services among different sectors of the economy, balanced by the flow of money made in exchange for those goods and services. The circular flow diagram consists of two kinds of flow:

• Product or real flow: - It is the flow of goods and services.
• Money flow: - It is the flow of rent, wages, interest and profit in terms of money.

In a monetized economy, the money flow is generated by the flow of factors of production which we call factor payments and it takes the form of factor income flows. These factor incomes are spent on consumer and capital goods, which take the form of expenditure flow. The expenditure flow is in the form of money flow. Both the expenditure as well as product flow in a circle in opposite directions. Therefore, the whole economic system can be viewed as a circular flow of factor income and expenditure. The magnitude of these flows determines the size of entire national income.

The circular flow of income and expenditure in the economy is based on the following basic principles:

• In any economic transaction, the total amount seller receives is equal to the amount buyer spends.
• Goods & services and money flow in opposite direction.
• There is a close relationship between income, output, and expenditure.

The flow of income and expenditure in a real economic system is really a complex process. In order to simplify the process, the economy is divided into four sectors: the household sector; business or firms sector, government sector, and foreign sector or rest of the world. All these four sectors are combined in order to form three different models of flow of income and expenditure:

1. Two sector model which consists of household and business sector
2. Three sector model which consists of household, business and government sector
3. Four sector model which consists of household, business, government and foreign sector.

Circular flow of income and expenditure in two sector economy

Under this model, the income and expenditure flow between two sectors of the economy i.e., (1) Household sector and (2) Business sector or firms. It represents a private closed economic model in which product and money flow between household and business. The government and foreign sectors are completely ignored by the model. A two-sector economic model is unrealistic in the present world because no economy is away from the participation of government. However, this model provides us a convenient way to understand the circular flow of the economy.

Assumptions:

1. There are only two sectors in the economy:
   • Business sector
     They do not own their own resources however, they hire factor of production (land, labor, and capital) from a household in order to produce goods and services. The productions are finally sold to the households.
   • Household sector
     They are the owners of all factor of production and provide these factors to the business sector. Their total income consists of returns from their factors of production in the form of wages, rents, interests and profits. They are the consumer of final goods and services produced by the business.
2. The government has no influence over the economic activities i.e. there is no any intervention or role of government in the functioning of the economy.
3. It is a closed economy, meaning there is no export or import activity undertaken by the business sector.

The circular flow of income in two sector economy is explained with the help of the following figure:

Two major sectors of the economy are represented by the rectangular box with their respective characteristics. The line joining households and firms divides the diagram into two parts. The upper part denotes factor market whereas the lower part denotes commodity or product market. In the both markets, two types of flow are seen i.e., product flow and money flow. The outer circle represents the real flow and the inner circle represents the monetary flow.

Factor market

It is the market where the factors of production like land, labor, and capital are purchased and sold. In the factor market in upper half, the factors of production flow from household to firms as a real flow. This real flow causes a reverse flow of factor incomes (wages, rent, interest, and profit) from firms to the household. All the factor income is made in terms of money and hence the flow of factor income is represented by money flow which is the total income of households. It can also be called as the flow of expenditure since one man’s income can be considered as another man’s expenditure and vice-versa.

Commodity market

It is the market where final goods and services are bought and sold. In the commodity market in lower half, the goods and services produced by firms flow from firms to household as a real flow. The payments made my households for the goods and services create money flow from household to firms.

• By adding up the value of all goods and services received in given period of time.
• By adding up the value of all the income received during that time-period.
• By adding up the value of all the spending that occurred during that period of time.

In each case, the result obtained should be identical as:

Total income=total production- total expenditure

In this way, the total demand of the economy will be equal to total supply. This position is called the position of equilibrium where the circular flow of income continues to operate regularly.

Leakages and injections in two sector economy

The scale of income and expenditure flows is determined by the capacity of the society’s income and expenditure. The larger the size of income and expenditure of society, the large will be the flow of income and expenditure and vice versa. But in the real world, there is leakages and addition in the circular flow of income and expenditure. The leakages and addition are also called as withdrawals and injections. 

Income that is not spent on domestically produced goods and services is referred as withdrawals. For example: If a household saves a certain amount of income for their old age or for any unforeseen incidents and do not spend unless required, then it is withdrawal. But when this saving is spent in the form of investment then it takes a form of injection. Similarly, the firms also sometimes may cut off their expenditure for the anticipation of depression which results in the injection.

On the other hand, the expenditures that add to the circular flow are referred as injections. It is the addition of income than what they actually earn. The injections by the households may be done by spending inherited savings, own hoardings or by borrowing and spending on consumer goods. The firms may inject money by spending their past savings of by borrowing from outside of the economy.

References

Dwivedi, D. N. (2010). Macroeconomic theory and policy. New Delhi: Tata McGraw-Hill Education.