Circular-flow diagram

Circular-flow diagram

Circular Flow of Income and Expenditure-Four Sector Economy

How do you explain the circular flow of income?

9. Circular Flow of Income: The circular flow means the unending flows of production of goods and services, income and expenditure in an economy. It shows the redistribution of income in a circular manner between production unit and households.

The government purchases goods from firms and also factors of production from households. Thus government purchases of goods and services are an injection in the circular flow and taxes are leakages in the circular flow.

income flow

Business Sector

This is a leakage because the saved money can not be spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector. An example of a group in the finance sector includes banks such as Westpac or financial institutions such as Suncorp. The three-sector model adds the government sector to the two-sector model. Thus, the three-sector model includes households, firms, and government.

Types of models

In the circular flow of the economy, money is used to purchase goods and services. Goods and services flow through the economy in one direction while money flows in the opposite direction. In explaining the flow of money, this economic model uses the terms “money flow” and “real flow” to designate the nature of the different exchanges that take place. The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents.

They are also linked through the factor market where the factors of production are sold and bought. It illustrates the balance between injections and leakages in our economy.

What Is Circular Flow of Income?

Learn about the simple model used to describe where money goes and what it is exchanged for in a market economy. The circular flow model of economic activity shows you the basic relationships between households, firms and the government. Just as money is injected into the economy, money is withdrawn or leaked through various means. Taxes (T) imposed by the government reduce the flow of income. Money paid to foreign companies for imports (M) also constitutes a leakage.

Five-sector model

The circular flow of income represents money moving through the economy. It shows how households purchase goods and services from firms by using the income they earned from firms by working for them. Firms use factors such as capital, labor, and land from households so they can produce the goods households purchase. When money leaves the circular flow of income in the form of savings, foreign goods, and taxes, leakages occur in the diagram. Injections are when money is added to the model in the form of government money, exports, or investments.

As long as leakages are equal to injections, the circular flow of income continues indefinitely. Financial institutions or capital market play the role of intermediaries. When the domestic business firms export goods and services to the foreign markets, injections are made into the circular flow model. On the other hand, when the domestic households, firms or the government imports something from the foreign sector, leakage occurs in the circular flow model. In the financial sectorIn terms of the circular flow of income model, the leakage that financial institutions provide in the economy is the option for households to save their money.

The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow analysis is the basis of national accounts and hence of macroeconomics. Money flow and real flow are the two main aspects of the circular flow of income economic model. Both refer to exchanges of goods and services for money, but the two concepts differ in how they refer to the opposite sides of these exchanges as they relate to individuals and companies.

  • The circular flow of income represents money moving through the economy.
  • It shows how households purchase goods and services from firms by using the income they earned from firms by working for them.
  • Firms use factors such as capital, labor, and land from households so they can produce the goods households purchase.

The government sector consists of the economic activities of local, state and federal governments. Flows from households and firms to government are in the form of taxes.

When money is added to the flow of income, it is called injections, because the money is injected into the economy. The five-sector model adds the financial sector to the four-sector model. Thus, the five-sector model includes households, firms, government, the rest of the world, and the financial sector. The financial sector includes banks and non-bank intermediaries that engage in borrowing (savings from households) and lending (investments in firms). Residuals from each market enter the capital market as savings, which in turn are invested in firms and the government sector.

It is important to note, that not all money will be used to purchase goods and services from firms. Sometimes, households will save their money, purchase foreign goods, or use their income to pay taxes.

income flow

What is circular flow of income class 12?

The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction.

When money is used this way, it’s called leakages because the money is leaked from the diagram and used somewhere other than for the purchase of goods and services. This extra money comes in the form of government money, exports, and investments.

When households and firms borrow savings, they constitute injections. Injections can take the forms of investment, government spending and exports.

Important Questions for class 12 economics Investment, Stock, Flows and Circular Flow of Income

However, this job is done by financial institutions in the economy. Figure 11 shows that taxes flow out of the household and business sectors and go to the government.

Alternative models

Half of the model includes injections, and half of the model includes leakages. The circular flow model shows where money goes and what it’s exchanged for. The model includes households, businesses and governments. We also have the banking system that facilitates the exchange of money and, as we’ll see in a minute, helps to productively turn savings into investment in order to grow the economy.

In a simplified economy with only two types of economic agents, households or consumers and business firms, the circular flow of economic activity is shown in Figure 10. Consumers and firms are linked through the product market where goods and services are sold.

income flow

The income the government receives flows to firms and households in the form of subsidies, transfers, and purchases of goods and services. Every payment has a corresponding receipt; that is, every flow of money has a corresponding flow of goods in the opposite direction. As a result, the aggregate expenditure of the economy is identical to its aggregate income, making a circular flow.

Circular-flow diagram

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