Less obviously, households ultimately sell the other factors of production to businesses as well. Rate of interest, which is the price for the use of savings, is determined by saving and investment. These are the leakages from the circular flow. The goods and services produced by these firms are consumed by households. If markets for goods and services were the only markets available, firms would eventually have all of the money in an economy, households would have all of the finished products, and economic activity would stop. In this way, the circular flows of income and expenditure remain in equilibrium. Disequilibrium happens when either household s or firms do not spend all their incomes.
A flow of money spending on imports has been shown to be occurring from the domestic business firms to the foreign countries i. However, an eminent British economist J. It will study a circular flow income in these sectors excluding rest of the world i. The four sector model includes foreign trade and transactions taking place in foreign trade sector. It follows from above that net capital flows S-1 always equal the trade balance or to current account balance which is the broader term that includes invisibles also in addition to trade of goods. Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors—the household, the business and the government. Governments levy taxes on households and businesses in order to provide certain benefits to everyone.
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. In the diagram, the sale of goods and services by firms to consumers in the product market is shown in the lower portion of the inner circle from left to right; and the sale of their services to firms by households or consumers in the factor market is shown in the upper portion of the inner circle from right to left. The equilibrium condition for maintaining the circular flow would still be that total leakage must equal total injections. The functioning of the free-market economic system is represented with and and interaction back and forth. It also receives royalties, interests, dividends, etc. On the other hand, taxes on business firms tend to reduce their investment and production. .
This is not to say that the circular flow diagram isn't useful in understanding the basics of an economy, such as leakages and injections. This will lead to a fall in the leakages until they equal the injections and a lower level of equilibrium will be the result. As shown again, the economic rsources of land, labor, and capital are provided by the households and used by the producing firms. The circular flow analysis is the basis of and hence of. T he go ve rn me nt se ct or wh ic h pe rf or ms ne ce ss ar y fu nc ti on s bu ys th e economic resou rces of land, labor, and capital from household s.
But each money flow is in opposite direction to the real flow. Thus money acts as a medium of exchange. Now, look at the gross national product or income in the simple economy from the viewpoint of its allocation between consumption and saving. This model is a simplification of economic activity, but it allows us to understand some central facts about market economies. The government levies taxes worth Rs.
Money facilitates such an exchange smoothly. Circular Flow of Income effects of saving To manage this problem, if disequilibrium were to occur in the five sector circular flow of income model, changes in expenditure and output will lead to equilibrium being regained. In order to continue functioning, businesses must spend money on the factors of production: land including physical land and any natural resources needed in their operations , labor, and capital money, buildings, equipment, and other goods. This process, called investment I , occurs because existing machinery wears out and because firms may wish to increase their capacity to produce. More Detailed Information The circular flow model concentrates on the relationship between the two primary groups of actors in the economy: households and businesses. Importance of Monetary Policy: The study of circular flow also highlights the importance of monetary policy to bring about the equality of saving and investment in the economy.
In this case, the government reduces the public debt and supplies funds to the capital market which are received by the business sector. When we give money to governments Central, State, Local in the form of taxes, our ability to spend is reduced but the government can offset the effect of this leakage through taxes by spending more on the purchase of goods and services called injection. Finally, the enormously complex financial industry may not be accurately accounted for by the basic version of the circular flow model. If government purchases exceed net taxes then the government will incur a deficit equal to the difference between the two, i. Circular Flow in a Two Sector Economy: We begin with a simple hypothetical economy where there are only two sectors, the household and business. They sell them to firms for producing goods and services. The circular flow of income and expenditure in such an economy is shown in Figure 1 where the product market is shown in the upper portion and the factor market in the lower portion.
Consumers and firms are linked through the product market where goods and services are sold. On the other hand, the government purchases all its requirements of goods of all types from the business sector, gives subsidies and makes transfer payments to firms in order to encourage their production. Th e int era cti on bet wee n hou seh old s and fi rm s re gar din g pr odu cti on, con sum pti on, employment and income generation results to the circular flow of goods and services in the economy. First, take the circular flow between the household sector and the government sector. Land receives rent, human capital receives a wage, real capital receives a rate of return, and enterprise receives a profit. 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.