CONCEPT OF CIRCULAR FLOW:
The circular flow refers to the flow of goods and services among different sectors of the economy, balanced by the flow of money payments made in exchange for those goods and services. It is called circular flow because it has no end. It goes round in a circle perpetually. Circular flow of income can be viewed from two different angles: (1) in the form of goods and services, called Real Flow, (2) in the form of money, called Monetary Flow.
Circular Flow of Income and Expenditure in a Two-Sector Economy:
Under this model, circular flow of income between two sectors of the economy i.e., (1) Household Sector and (2) Business sector or Firms is studied.
Assumptions:
1. There are only two sectors in the economy:
a. Business Sector or Firms
b. Household Sector
2. Government has no influence over the economic activities.
3. It is a closed economy, meaning thereby that no export or import activity is undertaken by the business sector.
On the basis of these assumptions, circular flow of income and expenditure is explained with the help of the following figure.
The outer circle represents real flow and the inner circle represents monetary flow. Real flow indicates that services of the factors flow from household sector to firms and goods and services flow from business sector to household sector. Monetary flow expresses that rent, wages interest and profit in terms of money flow from business sector to household sector. On the other hand, the expenditure on consumption of goods and services in terms of money flow from household sector to business sector.
Since the households spend their income, the total monetary receipts of business sector will be equal to the income and consumption expenditure of the household sector. In other words, monetary receipts of the producers = income of the households =consumption expenditure of the households. In this way, the total demand of the economy will be equal to total supply. This position is called position of equilibrium wherein the circular flow of income continues operate regularly.
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Circular Flow of Income and Expenditure in a Three-Sector Economy:
The three-sector model is formed by adding the government sector to the two-sector model. This sector includes the government, which plays an important role in the economy. It is necessary to include the effect of the fiscal operations of the government. However, only three fiscal variables (i.e. taxes, government spending on goods and services and transfer payments) are analyzed in this analysis.
Taxes are withdrawals from the flows because they reduce private disposable income and, therefore, consumption expenditure and savings. On the other hand, government expenditure is an injection into the income stream. The government expenditure adds to the aggregate demand in the form of government purchases of factor services from the households and goods and services from the business sector. The transfer payments by the government (i.e. old age pensions, subsidies, unemployment allowance, etc.) are injections to the circular flows. They add to the household income which leads to increase in household demand for consumer goods.
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Above figure represents a closed economy circular flow among the household, business, and government sectors. In the upper loop, individuals are paid for factor services and government receives indirect taxes which it imposes upon the output of goods and services. Individuals use their income payments to consume, save, and pay direct taxes to the government. Government spends tax receipts; individuals lend their savings to the business sector, which invests in new plant and equipment. In the lower loop, the spending flow includes consumption (C), investment (1), and government expenditures (G).
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Circular Flow of Income and Expenditure in a Four-Sector Economy:
The four-sector model is formed by adding foreign sector to the three models (i.e household sector, business sector and government sector). It consists of two kinds of international transactions: (i) foreign trade (ii) flow of capital and remittance.
Assumptions :
1. The external sector consists only of exports and imports of goods and services, made only by the firms.
2. The households export only labour and capital and receive remittance.
The circular flow of income and expenditure in a four sector model can be explained with the help of above figure. Presented as an above figure , the lower position of the centre flow shows circular flows of money in respect of foreign trade. Exports, as an injection to the economy, make goods and in services flow out of the country and make money flow into the country the form export earnings. Similarly, imports as the withdrawals from the circular flows, make flow of goods and services and flow of foreign exchange out of the country. Another flow is generated by the export of factor services, (especially, labour and capital) by the households. The export of these services brings in factor payments as a form of foreign remittances in terms of foreign exchange. These flows and outflows go on continuously so long as there is foreign trade and export and import of factor services.
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