Circular Flow of Income

Introduction: Circular Flow of Income

Money and other economic resources move in cycles in an economy from one sector to another. For example, money flows as wages from producers to workers. This money flows back to producers as payment for used products. In fact, when workers buy goods and services in the economy, they pay back the money to producers. In this way, in the simplest form of circular flow (two factors) circular flow, money and resources move between the producers and workers infinitely.

Although the two factors model is best to understand the circular flow of income, in reality, the process of flow of income is not so easy. In fact, there are more than two factors in most economies through which income moves.In the most complex process, there are five factors, namely −

• households (the public sector)
• businesses
• government
• foreign sector, and
• financial sector.

The primary motive for the circular flow of income is to detect how money moves within the economies. It breaks down the players of an economy into primary factors that gets and expense money. It shows the circular flow that shows how money and economic resources flow from one factor to the other and come back from one another too.

It is the ultimate cycle of representation of the movement of money and other resources within an economy. That is why it is called a circular flow although the nature of the process is simply like straight remittances from one sector to the other.

Apart from providing information on national income, the circular flow of income can be used to gauge the interdependence among the various sectors. It shows that the sectors are interdependent on one another and one cannot exist without the existence of the other. It also depicts the never-ending nature of economic pursuits, meaning that the flow of resources in the economy keeps running forever from one sector to the other and vice versa.

This is very important to know because without a circular flow there may be disruptions in the economic flow of money and resources. There is usually an equilibrium of expenditures and aggregate income which makes the economic process run forever.

The circular flow of income also helps to determine whether the injections and leakages are in excess. When injections outweigh leakages, the national income of a country will go up while in the case leakages are higher than injections, the national income of the nation will come down.

Different Forms of Circular Flow Models

Two Sector Model

It is the simplest form of a circular flow model. There are only two sectors, businesses, and households, in it. Here, economic resources and money flow from one sector to another and vice versa.

Three Sector Model

In the three sector model, there is another sector, that is the government which gets the flow of money and resources from households and businesses in the form of tax. The government then pays back in the form of subsidies, public services, etc.

Four Sector Model

In the four-sector model, apart from the three sectors in the three-sector model, another sector, that is foreign sector is included. The fourth sector or the foreign sector makes an economy a free economy. There are two ways in which money and resources flow in the four-sector model.

The first is foreign trade which contains imports and exports and the foreign exchange which consists of foreign exchanges.

Five Sector Model

The fifth sector that is added to the four-sector model in the five-sector model is the financial sector. The financial sector consists of banks and financial institutions that provide loans and other financial services. The five-sector model assumes the concept of savings and investment, which flow from the other four sectors in the form of residual cash.

This cash that accumulates in the financial institutions is then distributed to sectors that need money. For an equilibrium in the circular flow, the lending or injection must be equal to borrowing or leakage in the system.

Methods of Calculating National Income

The above-mentioned factors can be taken as components to calculate the national income of a country. There are mainly three ways to calculate the national income, which are as follows −

Product Method

In the product method, the final money value of all products prepared in the country in a year is used to calculate the national income of the country. The notable point here is that the final goods should be the ones that are consumed directly and not used to produce any new product. In other words, the final products must be used for consumption and not for production as raw materials.

In this process, the goods that are used to produce goods are known as intermediate goods. As the value of intermediate goods is already included final good, the value of intermediate goods is not counted to avoid double counting.

In order to ignore double counting, the value-addition method is used where instead of the value of the goods, the value addition (value of final good - value of intermediate good) is used. This value addition measurement is conducted in each stage of production to get the value of GDP. The GDP calculated in this way is known as GDP at a market value.

Income Method

When national income is calculated as the flow of factor incomes, it is called the income method of calculation. As we know, there are generally four factors of production - land, capital, labor, and entrepreneurship. The land gets rent, capital is used for interest on investment, labor is for wages and entrepreneurship gets profit as the remunerations.

Apart from these, there are people who get mixed-income, a term used to indicate people who use their own labor and capital, such as lawyers and doctors. The total added sum of all the factors mentioned is known as NDP at factor costs.

In other words, the national income in the income method is estimated by adding all factors of production, including rent, profit, wages, and interest, and the mixed income of the self-employed. It is a form of domestic income confined within the borders of a nation.

Expenditure method

In the expenditure method, national income is expressed as the flow of expenditure. The GDFP is considered the grand total of private consumption expenses, government consumption expenses, gross capital formation, and net exports.

Conclusion

The circular flow model has been widely used in macroeconomics in order to check and verify the well-being of the economies. Nations are naturally interested in calculating their incomes and the circular flow of income helps them to do it. It is therefore a concept of much reverence.

FAQs

Q1. Which is the simplest form of the circular form of income? How many sectors are there in it?

Ans. The two-sector form of the circular flow of income is the simplest form of the circular flow of income. It has two sectors, households and businesses.

Q2. By what name is the circular flow of income also known?

Ans. The circular flow of income is also known as the circular flow model.

Q3. What is meant by injections and leakages?

Ans. Lending refers to injections while borrowing is referred to as leakages.