Definition: The Circular Flow model represents the continuous flow of money among the sectors of the economy. The process of exchange results in economic activities like production, consumption, investment and expenditure. It plays a significant role at the time of calculating national income. The sectors include:
- Domestic or Household
- Corporate or Firms
- Foreign or Rest of the world
It shows the cycle of economic activity between these sectors of the economy. The level of flow is depicted through two, three and four sectors models.
There are certain leakages (saving) and injections (investment) in the economy. This results in an increase or decrease in the national income.
Content: Circular Flow Model
- Types of Flow
- Two-Sector Model
- Two-Sector Model with Saving and Investment
- Three-Sector Model
- Four-Sector Model
Types of Flow in the Model
There are two types of flow, Real flow and Money flow:
Real Flow: It is the mobilization of resources and commodities in the economy. For example, factors of production, goods and services.
This model shows the circular flow of income in the simple economy. Generally two sectors, i.e. household and firms. The domestic sector provides the factors of production to the firms like:-
The firms use these resources in the production of goods and services. The household spends its total income on the consumption of goods and services. On the other hand, firms make factor payments like:-
- Profits, etc.
Assumptions of a two-sector model
- The firms recruit factors of production from the domestic sector.
- The households consume goods and services produced by firms.
- There are no savings and investments.
- There are no borrowings among the households.
- Complete absence of foreign trade.
- No role of government.
Two-Sector Model with Saving and Investment
In this model, we assume that the household saves some amount from their income. The savings are the leakages from the economy.
Because of the simple or closed economy, the firms will get less money for production. Hence, it will affect the volume of production and decrease national income.
To maintain the flow of money, the firms borrow money from the financial markets. It is also called injections in the economy.
Therefore, in the two-sector model, the equilibrium is obtained when
S = I
Where S is Savings
The Three-sector model includes government along with domestic and corporate sectors. It plays a crucial role to maintain balance in the economy.
Government acts both as a producer as well as a consumer for both the sectors. It receives money in the form of direct and indirect taxes. It spends by giving subsidies, construction and services, etc.
The flow of income between government and different sectors are as follows:
- Household and Government: The government take factors of production (army, administration, etc.) from the household. It makes factor payments (salary, pensions, scholarships, etc.)to them. The households pay direct taxes to the government.
- Firms and Government: The government purchases goods and services of the firms. They provide subsidies to them. Firms pay corporate taxes to the government.
- Financial Market and Government: The government invests excess money into financial markets. It also borrows money from the market to pay off its expenses.
Therefore, in the three-sector model, the equilibrium is obtained when
C + S + T = C + I + G
Where C is consumption
S is savings
T is taxes
I is investments
G is government expenditure
The Four-sector model shows the flow of income in an open economy. It consists of economic activities between the three sectors with the rest of the world or foreign sector. The trade is made in the form of imports and exports with foreign countries. In an open economy, imports and exports affect the national income.
Assumptions of a four-sector model
- Only exports and imports of goods & services are taking place.
- The domestic sector exports only human resources and receives foreign remittances.
The flow of income between foreign and different sectors are as follows:
- Household and Foreign Sector: The household provides human resources and pays for imports to the foreign sector. They receive factor payments and transfer payments from the foreign sector.
- Firms and Foreign Sector: The firm exports goods and services to the foreign sector. They receive payments for the exports.
- Government and Foreign Sector: The government export and import goods and services to/from the foreign sector. They receive payment for the exports and make payment for the imports. Also, it receives payment in the form of duties and taxes at the time of foreign trade.
- Financial Market and Foreign Sector: The foreign sector both invest and borrow money from the financial market. For example, Foreign Direct Investment (FDI).
There can be three possibilities:
- Exports > Imports
- Increment in National Income
- The outflow of Goods and services
- Inflow of money
- Injection in the flow of income
- Imports > Exports
- Decrease in National Income
- Outflow of money
- The inflow of goods and services
- Leakage in the flow of income
- Imports = Exports
- A balanced flow of income
Therefore in the Four-sector model, the equilibrium is obtained when
Y = C + I + G + (X-M)
Where Y is Income
C is Consumption Expenditure
I is Investment Expenditure
G is Government Expenditure
Principles of Circular Flow Model
- In the exchange process, the amount purchased should be equal to the amount spent.
- The mobilization of goods and services should be in one direction. The receipts from them should be in the opposite direction.
- The real and money flow are opposites, which causes a circular flow.
- The income flow from sectors should always show receipts and payments.
Importance of Circular Flow Model
- It is a measure of National Income.
- Gives an idea about the injection or leakage in the flow of money.
- It shows the interdependence of economic sectors and their activities.
- Represents the overall health of the economy.
- The model helps to detect causes and remedies for the imbalance in the economy.
Limitations of Circular Flow Model
- Assumptions: These models are based on assumptions. It does not provide a clear picture of the economic equations.
- Non-Monetary Transactions: Non-monetary transactions are excluded from the model.
- Dynamic Environment: Continous changes are taking place in the economy due to the dynamic environment.
- Natural Disasters: Natural disasters cause huge damage to the countries economy. The decrease in the flow of money due to disasters are not included.
The circular flow model provides an idea about the working of the economy. It shows the flow of money among economic sectors through two, three and four sector models. The flow of income impacts the National Income of the country. Leakage and injections also affect the cycle by increasing or decreasing the flow of money.
There should be a balance in the flow of income in the economy. It may be achieved by the Fiscal and Monetary policies of the country.