The economy is a system in which each economic agent works and conducts their individual economic activity in an interrelated manner. This means that both consumers and producers are participating in the production and sale of products and services, and that both the government and control mechanisms are involved in these transactions. There are various flows involved in carrying out such economic activities, such as the movement of products and services. A macroeconomic circular flow model is made up of these product flows, factor input flows, product payment flows, and factor input payments flows.
The circular flow is a model or tool used in economics to illustrate the ongoing flow of production’s output and input, as well as payments made and receipts received in exchange for purchasing and selling output and inputs between producers, resource providers, and consumers.
The flow of payments and receipts for goods and services, as well as factor services, between various economic sectors, players, and agents is referred to as the circular flow of economic activities. It demonstrates the regular exchange of goods, factors, and money between the domestic, commercial, public, and international sectors via the product, resource/factor, and financial markets.
“A circular flow diagram is a simplified representation of the macro-economy. It shows the flow of money, goods and services, and factors of production through the economy.”
– Paul Krugman
Major Sectors/Actors in the Circular Flow Model
- Household Sector: Responsible for spending on consumption – Consumption
- Business Sector: In charge of investment spending – Production
- Government Sector: Responsible for government purchase and regulation in the economy
- Foreign Sector: It makes certain of the element known as net export- foreign economic activities.
Types of Flows in Circular Flow Model
The Physical/Real Flow: Real flow is the movement of elements and things between domestic, commercial, governmental, and international sectors.
The Monetary Flow: Financial flow is the movement of income from households to businesses and from businesses to households.
Markets to interact in Circular Flow Model
- Product/Output Market: This is where goods and services for consumers are purchased and sold.
- Input/Factor Market: Resources are purchased and traded in this market.
- Financial Market: Both short-term and long-term lending and borrowing activities are conducted in this sector.
TYPES OF CIRCULAR FLOW MODEL
- Two-Sector Circular Flow Model: Both the house-hold and commercial sectors are included.
- Three Sector Circular Flow Model: It includes household, business sector, and government sector.
- Four Sector Circular Flow Model: It includes household, business sector, government, and foreign sector.
Two-Sector Circular Flow Model
There are only two sectors in the economy, the household sector and the business sector, according to the circular flow paradigm in the two-sector closed economy (business firms). The domestic sector is the source of the production factors that the commercial sector pays for. Businesses that generate goods and services and earn money by selling those products to the household sector are referred to as being in the business sector.
The circular process starts with the flow of financial resources from households to businesses for production, followed by another flow of funds from businesses to households for consumption expenditures made by households.
Assumptions
- The household sector and the business sector are the only two economic sectors.
- No government intervention in economic activities.
- There is an absence of import and export by business sectors
- The owners of the producing factors are households.
- Firm employee factor services
- The financial sector only plays the role of intermediary to convert savings of the household to investments.
The following diagram can be used to better clarify the two-sector circular flow model based on the aforementioned premises:
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In a two-sector economy, the diagram depicts the continual circular movement of revenue and spending. The chart makes it apparent that money and factor services go in the opposite direction. This indicates that in the case of the two-sector circular flow model, actual flow and money flow travel in the opposing directions.
The movement of financial components from the business sector to the household sector is depicted in the upper half of the picture as rent, wages, interest, and profit.
The product market can be seen in the figure’s lower portion. In the product market, there is a real movement of goods and services from the business sector to the household sector, and in exchange, the household sector creates a monetary flow of price payments to the business sector. Savings from the household sector are transferred to the financial market, where they are lent to and invested in by the commercial sector.
In a two-sector economy, we may derive the continuous circular flow of income and spending by merging these two components.
Three Sector Circular Flow Model
The government sector, together with the household and corporate sectors, is a part of the three-sector circular flow concept. Hence, the family, business, and government sectors serve as the three main economic agents in the three sectors circular flow macroeconomic models. Even if the government is a part of the three-sector circular flow model, it is still considered that the economy is closed and that no outside sectors have any influence on the revenue flow.
Together with the income and expenses of households and businesses, this model also takes into account government purchases or expenditures as well as taxation. In this case, taxes constitute a leak while government purchases are injections into the circular flow.
The household sector pays income tax and commodity tax to the government, according to the flow of income and expenditure between the household sector and the government. In a similar vein, the government provided transfer payments to the household sector in the form of pension funds, assistance, sick pay, health, education, and other benefits.
The corporate sector and the government have a comparable revenue and expenditure flow. Business organizations pay taxes, and the government also provides a variety of production subsidies, makes transfer payments, and pays for the goods and services it buys from the commercial sector.
The leakages from the circular flow in this case are the taxes paid by individuals and businesses. The decreases not just the home sector’s consumption and savings, but also the corporate sector’s investments and output. However, the government makes up for the leakages by paying for household sector services as well as commercial sector goods and services. As a result, the circular flow reaches equilibrium as the economy’s supply and demand levels are equal.
To cover current expenses or to invest in various projects, the government borrows a set amount of its income from the capital market.
Assumptions
- The whole economic activities are organised by three major sectors: households, business and government.
- There is no external trade and the economy is closed.
- Government affects the economy by using taxation, transfer payments, and business subsidy.
- Households and business sectors pay taxes to the government.
- There is the existence of perfect competition.
- There is a well-managed financial market.
Based on the above assumptions, the three-sector circular flow model can be further explained with the help of the following diagram:
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The government sector is added to the two-sector model to create the three-sector circular flow model. The government collects direct taxes from the households in the upper part of the picture, where it can be shown that households are compensated for their factor services. In a similar vein, businesses are subject to both direct and indirect taxes by the government. The government receives its revenue from both direct and indirect taxes together. The government spends the tax money that is given to businesses, homes, and individuals in the form of subsidies, wages, salaries, and transfer payments.
Four Sector Circular Flow Model
A realistic representation of the circular flow of an economy can be found in the four sector circular flow model. The household sector, business sector, government sector, and foreign sector are the four sectors that make up the four-sector model, which investigates the circular flow in an open economy.
Net exports make up the international sector. The difference between export and import is known as net export (X – M). As a result, it is also known as the “open economy” and comprises of two different types of global trade.
Foreign Trade
Flow of Capital: The economies of the globe are becoming more open and integrated in the current era of globalization. As a result, the foreign industry is crucial to the economy. Injections are made into the circular flow model when domestic companies export goods and services to overseas markets. On the other hand, leakage develops in the circular flow model if domestic enterprises or the government import from foreign organizations and firms.
Assumptions
- The whole economic activities are organized under four distinct economic sectors: household, business, government, and foreign sector.
- Household supply resources to domestic and foreign firms, they obviously supply resources of production to the homeland government.
- It is an open economy.
- The enterprises’ exports and imports of goods and services are included in the overseas sector.
- Household sector export labor and capital only.
- There is minimal government intervention.
- The marketplaces, both internal and external, are perfectly competitive.
- There is a well-managed financial market.
- Only commodities and services are exported and imported by business firms.
Based on the above assumptions, the factor-sector circular flow model can be further explained with the help of the following diagram.
Sourced from: https://enotesworld.com/
Resources are provided by households to the private, public, and domestic business sectors. People pay taxes to the government, buy products and services from businesses, and receive income from both the government and businesses.
People also buy products and services created abroad (imports). Households in particular provide labor services to foreign countries in today’s more globalized world and receive remittance revenue. Additionally, they put their money to work abroad and earn profits.
The company is paid for its goods and services by consumers and the government; it also sells its products to other countries (exports) and earns money; it pays wages, dividends, interest, and rent to consumers; and it pays taxes (indirect taxes and corporate profit taxes) to the government. Also, it brings in goods and services from abroad. As a result, the business sector both pays for the imports it purchases and benefits from the exports it makes to other nations.
Taxes are paid to the government by both corporations and individuals (households pay income and property taxes). It covers costs for households, businesses, and government employees’ salaries as well as for goods and services. Additionally, it disburses payments to households (such as old age benefits, unemployment benefits, and pensions of retired government employees) and pays interest.
The business sector receives subsidies from the government. Public goods produced by the government include things like streetlights, public highways, telecommunications, hydropower generation, and national security.
People from other nations buy goods and services made in the country, tying the domestic economy to the global economy. This is the part of the domestic economy that deals with export trade. Similar to this, local citizens also buy (import) products and services from abroad. To calculate net exports in an overall examination of the foreign sector, the value of total exports must be subtracted from the value of total imports. Net exports are calculated as total export value less total import value. We say there are negative net exports and a foreign trade deficit if the value of imports is higher than the value of exports. The nation must borrow from other nations, entice more foreign direct investment (FDI), or sell more domestic assets to foreigners in order to finance its foreign trade imbalance.
The domestic economy and the foreign economy, or the Row sector, are linked through a variety of channels in the four sector circular flow model, including exports of goods and services, imports of goods and services, inflows and outflows of human labor, and inflows and outflows of financial capital and physical capital.
Leakages and Injection in Circular Flow Model
The circulation flow model must function with both injections and leakages. The circular flow model is incoherent since it includes leakages and injections. Injections refer to the addition of income and capital to the circular flow model, whereas leakages refer to the divergence of income or capital from the economic circulation.
The amount of revenue flow falls when there are leaks, and it increases when there is an economic injection. Leakages happen when households limit their use of goods and services and remove money from the circular flow paradigm.
This is a list of the main types and sources of leakage in the circular flow model.
Saving: It is the portion of revenue that the household does not use to make purchases, pay bills, or cover other expenses. Savings are stored with banks and other financial organizations, and these savings can also be lent by banks to businesses for capital development or investment.
Taxes: It is the income that households and commercial enterprises give to the government. This payment made by individuals and companies also lowers the income generated by the circular flow concept.
Imports: It is the sum of money that domestic companies give to the international market in exchange for the goods and services they receive from them. Income from the home economy is also lost due to import.
By summing the total amount of savings, tax payments, and import payments, one can calculate the overall leakage of the economy.
Leakage thus determines the quantity of income from the income flow in a circle.
Leakages = S + T + M
Here, the letters S represent for savings, T for taxes, and M for imports.
Injections
In the circular flow model, injections refer to an increase in the income flow. Exports, government spending, and investment are all regarded as types of injections. The amount of income in the circular flow is increased by any type of injection. There are primarily three types of injection, which are succinctly described below.
Investment: The entire amount spent by commercial firms on capital goods constitutes investment, one of the types of injections in the circular flow model. Investments are essentially an expansion of the capital stock. Increasing the flow of commodities into the market is helpful.
Government Expenditure: This type of injection covers the overall amount spent by the government on the acquisition of goods and services, as well as subsidies to commercial enterprises and transfer payments to household sector participants. Transfer payments include, but are not limited to, government payments including social security benefits, pensions, allowances, retirement benefits, and short-term assistance to struggling families.
Exports: The payment provided by the foreign sector for the acquisition of products and services produced by domestic enterprises constitutes another type of injection in the circular flow paradigm. With the aid of the established financial system, it also increases the inflow of revenue to the domestic circular flow model.
Injection = I + G + X
Here, the letters I, G, and X stand for investments, government spending, and exports, respectively.
The open economy’s equality between injections and leakages ensures
(S – I) = (G – T) = (X – M)
The circular flow of an economy will be in a balanced state if leakages are exactly equal to injections, as was previously demonstrated The country’s national income will rise if injections outpace leakages. On the other hand, if leakages outweigh injections, the nation’s gross domestic product will fall.