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LEARNING UNIT-2National Income AccountingCircular Flow of Income

Recommended ReadingH.L. Ahuja Ch. 1

LMS System Ch. 2

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Lecture Outline• Welcome• Key Concept:

- Meaning Circular Flow- Types of Circular Flow- Two Sector Model- Three Sector Model- Four Sector Model

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Circular flow of Income• The term circular flow of income or circular flow of economic activity refers to “a simple economic model which describes the circulation/flow of income between producers and consumers”.

• In the circular flow model, producer and consumer are referred to as "firms" and "households" respectively.

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Significance of Circular Flow• Measurement of National Income• Knowledge of Interdependence• Unending Nature of Economic Activities

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Two Sector Model•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 exchanges in a closed circuit and correspond in value, but run in the opposite direction. The circular flow analysis is the basis of national accounts and hence of macroeconomics.

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Basis Assumptions • The economy consists of two sectors: households and firms.• Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).• All output (O) produced by firms is purchased by households through their expenditure (E).• There is no financial sector.• There is no government sector.• There is no foreign sector

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HouseholdIt is a person or a group of people that share their income. The members of households have two functions:• They supply different factors of production• Members of household also work as consumers

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FirmsAn organization that produces goods and services for sale. Main objective is to maximize profit in the production process. The two main functions are as follows:• Produce goods and services and supply them in the market.• Firms purchase inputs or raw materials from households to use them in the production process

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Explanation of Figure• Firstly, the household sector supply their factors of production or factor services (labor, land, capital...) to the business sector through the factor market.• Secondly the business sector pays the rewards to household sector for their contribution to the production in kinds of rent for land, interest for capital, and wages for laborers…• Thirdly business sector supply their outputs or goods and services in the goods or product market.• Fourthly household sector pays their income for consumption expenditure.

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Explanation of Figure ….Here we saw product market and factor market. Factor market refers to the market for selling and purchasing or hiring of factors of production like labor, land …Product market means the market in which the goods and services are supplying and demanding.

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CFM with Saving & Investment• When household save, their expenditure on goods & services will decline to that extent and as a result money flow to the business firms will contract.• With reduced money receipts, firm will hire fewer worker or reduce the factor payments.• This will lead to the fall in total incomes of the households. Thus, saving reduces the flow of money expenditure to the business firms and causes a fall in economy’s total income.• Economists therefore call savings a leakage.

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CFM with Saving & Investment ….• Business firms borrow from the financial market for investment in capital goods such as machines, factories, tools & instruments etc.• Thus, saving again brought into the expenditures stream and as a result total flow of spending does not decrease.• So, investment is called as injection to economy.

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Three Sector Model•Three sector model is created by adding the Government sector to the Two sector model between economic agents.•Three kinds of monetary flows between the government and the rest of the economy i.e.

1) Direct taxes on both households and firms

2) Government expenditure3) Transfer payments and Subsidies

• Government spends a part of its tax revenue as factor payments to the households and a part in the form of transfer payments as pension and food subsidy etc

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