Circular Flow of Income

Circular Flow of Income Definition

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.

Key Takeaways

Diagram of the Circular Flow of Income

The flow of money in society can be referred to in the diagram below:

Circular Flow of Income

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

Example

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

  • 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. 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 incomeCalculate Per Capita IncomeThe per capita income formula depicts the average income of a region computed by dividing the total income of that area by the total population of the region. It is used to figure out the average income of a city, provision, state, country, etc.read more, GDPGDPGDP or gross domestic product refers to the sum of the total monetary value of all finished goods and services produced within the border limits of any country. GDP determines the economic health of a nation. GDP = C + I + G + NXread more, and other macroeconomic factorsMacroeconomic FactorsMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists.read more integral to formulating national and international economic policies.

Also, the liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more 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 in the 2, 3, and 4 sector economic models, respectively.

Circular Flow of Income in 2 Sector Economy

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.

Circular Flow of Income in 2 Sector Economy

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  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.

Circular Flow of Income in a Three-Sector Economy

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

Circular Flow of Income in a Three-Sector Economy

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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 the form of 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.

Circular Flow of Income in A Four Sector Economy

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

Circular Flow of Income in A Four Sector Economy

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 deficitTrade DeficitWhen the total sum of goods or services that a country imports from other countries is higher than the total sum of goods or services that a country exports to other countries, this is referred to as a trade deficit, which is the opposite of the balance of trade theory.read more. 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.
  6. 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.

This has guided the Circular Flow of Income and its definition. Here we discuss how it works in two-sector, three-sector, and four-sector economies along with diagrams and examples. You may learn more about financing from the following articles –