Circular Flow of Income

Circular Flow of Income Definition

Circular flow of income is an economic model that describes how the money exchanged in the process of 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

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Circular Flow of Income (wallstreetmojo.com)

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

Let understand the meaning of these terms as well as 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 which 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 it land to establish the factory will enjoy heavy 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 is running on several thriving circular movements of money. Obviously, 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, foreign trade and the like. Two and Three sectors of economy model respectively look at such issues.

Also, the circular flow of income caters to the need of including the complexities of income and expenditure. The circular flow of income helps to 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 factors that are integral to formulate 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 a recession, the volume will decrease due to a decrease in national income. In contrast, it will increase in case of boom due to an increase in national income.

These complexities can be understood by learning about the circular flow of income in 2, 3, and 4 Sector Economy model, respectively.

Circular Flow of Income in 2 Sector Economy

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

Circular Flow of Income in 2 Sector Economy

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Circular Flow of Income (wallstreetmojo.com)

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

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Circular Flow of Income (wallstreetmojo.com)

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 as it consumes a major portion of the money flow in the form of taxes.
  2. Hence, the flow of money follows from the firms and households to the government in the form of taxes.
  3. The government utilizes taxes to develop the infrastructure and many other services like healthcare, education, etc. So, to the firms, the government pays back in terms of incentives and by purchasing their goods.
  4. The government pays to the households in terms of interest rates on government securities, pay revisions, government jobs etc.
  5. Thus 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. 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 a step 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. By the introduction of the foreign sector, the scope widened 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 their goods and services, also called exports.
  3. If the value of imports is equal to the value of exports, it is called balanced trade. If imports are greater than exports, it is referred to as a trade deficit. If exports are greater than imports then 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, it was reported the United States had a trade balance deficit of around USD 922.78 billion.
  6. Thus, it can be said that the foreign players are investing in the US market, or the US firms are relying on the foreign market to fulfill their production needs and vice-versa.

This has been a guide to 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 –