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Main features five sector circular flow model equilibrium

Circular Flow of Income: Let us make in-depth study of the circular flow of income in two sector, three sector and four sector economy. Real flows of resources, goods and services have been shown in Fig.

Main features five sector circular flow model equilibrium

In the upper loop of this figure, the resources such as land, capital and entrepreneurial ability flow from households to business firms as indicated by the arrow mark. In opposite direction to this, money flows from business firms to the households as factor payments such as wages, rent, interest and profits.

In the lower part of the figure, money flows from households to firms as consumption expenditure made by the households on the goods and services produced by the firms, while the flow of goods and services is in opposite direction from business firms to households.

Thus we see that money flows from business firms to households as factor payments and then it flows from households to firms.

Thus there is, in fact, a circular flow of money or income. This circular flow of money will continue indefinitely week by week and year by year.

This is how the economy functions. It may, however, be pointed out that this flow of money income will not always remain the same in volume. In other words, the flow of money income will not always continue at a constant level. In year of depression, the circular flow of money income will contract, i. This is so because the flow of money is a measure of national income and will, therefore, change with changes in the national income.

  1. However, households who view the rate of interest as return on savings feel encouraged to save more. Importance of Trade Policies.
  2. However, an eminent British economist J.
  3. Figure 2 shows that the equality between saving and investment comes about through the credit or capital market. This circular flow of money will continue indefinitely week by week and year by year.

In order to make our analysis simple and to explain the central issues involved, we take many assumptions. In the first place, we assume that neither the households save from their incomes, nor the firms save from their profits. We further assume that the government does not play any part in the national economy. In other words, the government does not receive any money from the people by way of taxes, nor does the government spend any money on the goods and services produced by the firms or on the resources and services supplied by the households.

  • In order to make our analysis simple and to explain the central issues involved, we take many assumptions;
  • This is how the economy functions;
  • If savings exceed investment expenditure, rate of interest falls so that, at a lower rate of interest, investment increases and both become equal.

Thirdly, we assume that the main features five sector circular flow model equilibrium neither imports goods and services, nor exports anything. In other words, in our above analysis we have not taken into account the role of foreign trade. In fact we have explained above the flow of money that occurs in the functioning of a closed economy with no savings and no role of government.

Circular Income Flow with Saving and Investment: In our above analysis of the circular flow of income we have assumed that all income which the households receive, they spend it on consumer goods and services. A result, circular flow of money speeding and income remains undiminished. We will now explain if households save a part of their income, how their savings will affect money flows in the economy.

With reduced money receipts, firms will hire fewer workers or lay off some workers or reduce the factor payments they make to the suppliers of factors such as workers.

This will lead to the fall in total incomes of the households. Economists therefore call savings a leakage from the money expenditure flow. But savings by households need not lead to reduced aggregate spending and income if they find their way back into flow of expenditure.

In free market economies there exists a set of institutions such as banks, insurance companies, financial houses, stock markets where households deposit their savings.

All these institutions together are called financial institutions or financial market. We further assume that there are no inter-households borrowings. It is business firms who borrow from the financial market for investment in capital goods such as machines, factories, tools and instruments, trucks.

Firms spend on investment in order to expand their productive capacity in future. Thus, through investment expenditure by borrowing the savings of the households deposited in financial market, are again brought into the expenditure stream and as a result total flow of spending does not decrease. Circular money flow with saving and investment is illustrated in Fig. Money flow of savings is shown from the households towards the financial market.

Then flow of investment expenditure is shown as borrowing by business firms from the financial market. Condition for the Constancy of Circular Income Main features five sector circular flow model equilibrium Now the question arises what is the condition for the flow of money income to continue at a steady level so that it makes possible the production and subsequent flow of a given volume of goods and services at constant prices. To explain this we have to introduce saving and investment in the analysis of circular flow of income.

Saving a part of income means it is not spent on consumer goods and services. In other words, saving is withdrawal of some money from the income flow.

On the other hand, investment means some money is spent on buying new capital goods to expand production capacity. In other words, investment is injection of some money in circular flow of income.

For the circular flow of income to continue unabated, the withdrawal of money from the income stream by way of saving must equal injection of money by way of investment expenditure. Therefore, planned savings must be equal to planned investment if the constant money income flow in an economy is to be obtained. Now, what will happen if planned investment expenditure falls short of the planned savings?

As a result of fall in planned investment expenditure, income, output and employment will fall and therefore the flow of money will contract. If the equality between planned savings and planned investment is disturbed by increase in savings, then the immediate effect will be that the stocks of goods lying in the shelves of the shops will increase as some of the goods will not be sold due to the fall in consumption i. Owing to the deficiency of demand for goods and the accumulation of stocks, retailers will place small orders with the wholesalers.

Thus the ultimate effect of either the fall in planned investment or the increase in planned savings is the same, namely, the fall in income, output, employment and prices with the result that the flow of money will contract.

Main features five sector circular flow model equilibrium

On the other hand, if the equality between planned savings and planned investment is disturbed by the increase in investment demand, the result will be increase in income, output and employment. Consequently, the flow of money income will expand. It is thus clear from the above analysis that the flow of money income will continue at a constant level only when the condition of equality between planned saving and investment is satisfied.

  • On the other hand, if the equality between planned savings and planned investment is disturbed by the increase in investment demand, the result will be increase in income, output and employment;
  • Importance of Monetary Policy:

It was believed by classical economists that financial market provides a mechanism which coordinates the savings of households and the investment expenditure, by the firms.

Rate of interest, which is the price for the use of savings, is determined by saving and investment.

  • Importance of Fiscal Policy;
  • Consequently, the flow of money income will expand;
  • If exports are equal to the imports, then there exists a balance of trade;
  • Government expenditure may be financed through taxes, out of assets or by borrowing.

If savings exceed investment expenditure, rate of interest falls main features five sector circular flow model equilibrium that, at a lower rate of interest, investment increases and both become equal. On the contrary, if investment expenditure is greater than savings, rate of interest will rise so that at a higher rate of interest savings increase and become equal to planned investment expenditure.

However, an eminent British economist J. Keynes refuted the above argument that changes in rate of interest will cause saving and investment to become equal. Despite the fact that people who save are different from the business firms which primarily invest, in national income accounts savings are identical or always equal to investment in a simple two sector economy having no roles of Government and foreign trade.

This is a basic identity in national income accounts which needs to be carefully understood. Of course, in our above analysis of circular flow of income, we explained that planned investment by business firms can differ from savings by household.

But in that analysis we referred to planned or intended investment and savings which often differ and affect the flow of national income. However, in national income accounts we are concerned with actual saving and actual investment. We can prove their identity in the following way. In a simple economy which has neither government, nor foreign trade, the value of output produced which we denote by Y is equal to the value of output sold.

A pertinent question which arises here is what happens to the unsold output.

Circular Flow of Income: 2 Sector, 3 Sector and 4 Sector Economy

This may be considered as the firms selling the goods to themselves to add to their inventories. Thus, gross national product GNP produced is used either for consumption or for investment. Now, look at the gross national product or income in the simple economy from the viewpoint of its allocation between consumption and saving.

Since national income which is equal to GNP can be either consumed or saved. Thus, the identity iii shows that the value of output produced or sold is equal to the total income received. It is income received that is spent on goods and services main features five sector circular flow model equilibrium.

In our above analysis of money flow, we have ignored the existence of government for the sake of making our circular flow model simple. This is quite unrealistic because government absorbs a good part of the incomes earned by households. Government affects the economy in a number of ways. Here we will concentrate on its taxing, spending and borrowing roles. Government purchases goods and services just as households and firms do. Government expenditure takes many forms including spending on capital goods and infrastructure highways, power, communicationon defence goods, and on education and public health and so on.

These add to the money flows which are shown in Fig. It will be seen that government purchases of goods and services from firms and households are shown as flow of money spending on goods and services.

  1. Despite the fact that people who save are different from the business firms which primarily invest, in national income accounts savings are identical or always equal to investment in a simple two sector economy having no roles of Government and foreign trade.
  2. They also receive royalties, interests, dividends, profits, etc.
  3. The circular flow model of the circular flow of economic activity is a model showing the basic economic relationships in the circular flow of the.

Government expenditure may be financed through taxes, out of assets or by borrowing. The money flow from households and business firms to the government is labelled as tax payments in Fig. Transfer payments are treated as negative tax payments. Another method of financing Government expenditure is borrowing from the financial market. This can be represented by the money flow from the financial market to the Government and is labelled as Government borrowing To avoid confusion we have not drawn this money flow from financial market to the Government.

Government borrowing increases the demand for credit which causes rate of interest to rise. The government borrowing through its effect on the rate of interest affects the behaviour of firms and households.

Business firms consider the interest rate as cost of borrowing and the rise in the interest rate as a result of borrowing by the Government lowers private investment. However, households who view the rate of interest as return on savings feel encouraged to save more.

The Circular Flow of Income: Meaning, Sectors and Importance

It follows from above that the inclusion of the Government sector significantly affects the overall economic situation. To finance the deficit budget, the Government will borrow from the financial market. For this purpose, then private investment by business firms must be less than the savings of the households. Thus Government borrowing reduces private investment in the economy. In other words, Government borrowing crowds out private investment.

We now turn to explain the money flows that are generated in an open economy, that is, economy which have trade relations with foreign countries. Thus, the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries.