Circular Flow of Income

A circular flow of income is an economic model that describes how the money exchanged in the production, distribution, and consumption of goods and services flows in a circular manner from producers to consumers and back to the producers.

Therefore, the concept connects the household with the business and the government and gives us a clear idea about how the income is generated, distributed and effectively used in the economy. The entire process of economic cycle related to income is explained in a very simplified manner which is easy to interpret.

• The circular flow of revenue is an economic theory that describes how money circulates between businesses, producers, and households. Due to its focus on just two sectors—households and businesses—this model is also known as a two-sector economy.
• In the real world, there are many more participants, including the government, national income, the economy, and overseas markets. Despite the increased complexity, there is still a cyclic revenue flow.
• To address these issues with the two-sector economy, other models are utilized to comprehend the macro-level movement of money. A three-sector economy model and a four-sector economy model are these models.

The process of circular flow of income macroeconomics explain how the income flows from an individual or a household to the business, the government and then back to the household. The method of income generation and distribution is explained with a lot of clarity in the model.

The main components of the concept are household, business, government and the market. The household is the group of people who supply the factors of production, which is the land, labor and capital, to the business and get a return for the same. On the other hand, it is the household that buy that buy the goods and services from the business.

Next comes the business who are the manufacturers of products and services. They hire the factors of production and use them in the manufacturing process. The manufactured goods are them produced and sold back to the other businesses or household.

Then comes the government which participates in the process. The main ole of the government is to levy tax on the business and the household. The tax collected is then used for developmemt of infrastructure projects for public use. The money is also used for giving subsidy to corporates or households.

The market is where the goods and services are purchased or sold. The households buy the ready goods from the business and the business buys the factors of production from the household.

Thus, this model makes a simplified representation of the entire working of real economy. But in the actual situation, other factors are also to be taken into consideration, like savings, investment, international trade, etc.  But this model gives us a basic idea about how the income flows and how the various market elements interact with each other.

The flow of money in society can be referred to in the circular flow of income diagram. The circular flow of income is an integral concept in economics as it describes the foundation of the transactions that build an economy. However, the basic model of the circular flow of income considers only two sectors - the firms and the households - which is why it is called a two-sector economy model.

Let's understand the meaning of these terms and the whole concept in simple steps.

• Firms are the producers of goods and services, and therefore, they require various production or societal resources to produce goods and services.
• The factors of production are land, labor, building, stock, stationery, etc.
• Households provide the resources or factors of production. For example, a household provides land and labor to carry out business operations in exchange for the money paid in rent, wages, etc.
• So, the money flows from the firms to the household in rent, wages, etc.
• The households utilize wages and rent to purchase certain goods and services to fulfill their needs and wants.
• When the households pay for these goods and services, the money flows back to the firms, completing the circular movement of money.

We can take the example of a Nutella factory to explain the circular flow of income macroeconomics.

• Here, the Nutella factory is the firm that is the producer of jars of Nutella spread. Some of the factors of production include cocoa beans, land for housing the factory, the building, and laborers for carrying out the production process.
• The household that has rented out its land to establish the factory will enjoy monetary compensation or rent in exchange. Simultaneously, the labor will be compensated with wages in exchange for their hard work to produce jars of the chocolate spread.
• The logistics team will be paid further for delivering the Nutella jars to stores and e-commerce warehouses.
• The household will purchase the Nutella jar utilizing the money it earned as wages or rent.
• When households pay for the Nutella jars, the money will reach the factory owners, completing the money’s circular flow.

It is important to note that the economy runs on several thriving circular money movements as per the circular flow of income diagram. The above example is simplistic.

For a macro-level understanding, the two-sector model is not sufficient as many complex factors are not considered to explain the flow of income and expenditure. The factors include national income, the role of the government, and foreign trade. The three or four sector economy models respectively look at such issues.

Furthermore, the circular flow of income caters to the need to include complexities of income and expenditure. The circular flow of income helps calculate per capita income, GDP, and other macroeconomic factors integral to formulating national and international economic policies.

Also, the liquidity may vary over a period, i.e., the volume of money circulating in the economy may change depending on the economy’s state. So, if it is in recession, the volume will decrease due to a decrease in national income. In contrast, it will increase in a boom due to the increased national income. We can understand these complexities by learning about the circular flow of income model in the 2, 3, and 4 sector economic models, respectively.

Like we said before, the two-sector economy is a fundamental model consisting of only two sectors, firms, and households. Other assumptions of this model are as follows.

1. There are no savings by the households. Whatever they earn, they spend in the form of consumer expenditure.
2. Firms retain no profit, and whatever they earn from selling goods and services is given back to households in wages, rent, etc.
3. There is no government interference in the money flow, i.e., there is no tax liability on the households or regulations imposed on the movement.
4. It is assumed that it is a closed economy without any external interference from foreign countries, i.e., there is no foreign trade.

Some of these drawbacks are rectified in the three-sector model.

The three-sector economy model includes the role of government when determining the flow of money. In this type of economy, the government plays an essential part.

A three-sector economy model rectifies some of the drawbacks of the two-sector model by introducing the following.

1. The government plays a pivotal role in consuming a major portion of the money flow in taxes.
2. Hence, the flow of money follows from the firms and households to the government in taxes.
3. The government utilizes taxes to develop infrastructure and other services like healthcare, education, etc. So, the government pays back in terms of incentives and purchases goods from the firms.
4. The government pays the households interest rates in government securities, pay revisions, government jobs, etc.
5. Together, it all completes the circular movement of money.
6. If the government’s income from the taxes is less than its expenditure, it is said to have a deficit budget.

As such, the role of government cannot be ignored in any economy because of such a huge control it possesses over the economic cycle. Consequently, governmental interference affects the overall economic performance of a country.

A three-sector economy does not consider the role of foreign markets, which has become even more prevalent in the current globalized world.

The four-sector economy circular flow of income model is an open-ended economy that goes beyond by considering the foreign sector’s role in the overall economic cycle.

The main features of the four-sector economy are as follows:

1. With the introduction of the foreign sector, the scope widens further. The money flows to households or firms when they buy goods and services from a foreign country, also known as imports.
2. The money flows back to households when foreign countries give them employment. For firms, money flows back when foreign countries purchase goods and services, also called exports.
3. If the value of imports is equal to the value of exports, it is called a balanced trade. If imports are greater than exports, it is a trade deficit. If exports are greater than imports, it is called a trade surplus.
4. However, in the diagram, for the sake of simplicity, the trade relation (for goods and services) is shown only between firms and foreign markets.
5. In 2019, the United States had a trade balance deficit of around USD 922.78 billion.

Thus, we can say that the foreign players are investing in the US market, or the US firms rely on the foreign market to fulfill their production needs and vice-versa.

The concept of circular flow of income plays an important role in the economic environment and is useful in understanding several key aspects and functions o the financial market. Some points of importance are as follows:

• The process clarifies how the business and the household are interconnected and interdependent. Household provides factors of production to the business, which converts it into goods and services and sells it back to the household.
• The process of income generation is also well explained. Not only income generation, but its distribution is also explained among various economic agents. Understanding this process is very vital in order to evaluate the fairness and efficiency of the economic system.
• It helps in identifying and leakage or fraud in the economic system. It is essential to identify them so that the economy remains in equilibrium.
• The overall economic performance can be evaluated to understand the impact of reduction in consumer spending or increase in government investment.
• It helps the policy makers design and implement economic policies, in terms of taxation, government spending, control of demand and supply forces, etc.
• It helps in the analysis of complex models related to unemployment, inflation, economic growth or business cycles.

Thus, it has a number of real world applications that are required to make informed decisions regarding investment, consumption and production.

This has Guide to what is a Circular Flow Of Income. We explain it in a 2-sector economy, the diagram, along with 3-sector & 4-sector economy. You may learn more about financing from the following articles –

• Circular Economy
• Neutrality of Money
• Velocity of Money Formula