The circular flow of income or the circular flow model is a simple economic model that shows the circulation of money between producers and consumers within an economy. It refers to the flow of goods and services among the various sectors of the economy, balanced by the flow of monetary payments made in exchange for those goods and services.
The circular flow income is called so because the movement of income and expenditure continues throughout the economy and repeats itself, forming the circular flow of income.
The two basic aspects of circular flow model are consumers and producers. Consumers are the households that provide factors of production such as land, capital, labor, etc. to the producers or the firms that use these factors of production and make the goods and services available to the households in return.
The basic economic purpose of households or consumers is to supply the producers with the required factors of production- land, labor, capital, and entrepreneurship. The factor owners provide these factors of production in return for the reward they receive as income. Households then spend the income to fulfill their wants and needs in the form of consumption expenditure.
Business firms are the producers that utilize the factors of production to produce goods and services that meet the unlimited needs and wants of the consumers or households. In return for the factors of production received, business firms make payment to the households in the form of rent, interest, wages, and profit. These firms also get income in return for the goods and services they supply to the households.
In the circular flow model, the expense made by one sector becomes the income for the other sector, and the goods and services produced by firms is the demand made by the households. The model assumes that during the exchange process, the firms receive the same amount as spent by the households, and the only source of goods and services for the households are the business firms.
The model can be viewed from two different perspectives:
- The flow of goods and service, called Real Flow
- The flow of money, Monetary Flow
Real Flow of income implies the flow of factor services from the household sector to the business sector and the corresponding flow of goods and services from the business sector to the household sector.
Monetary flow refers to the transfer of factor income viz. rent, wages, interest, and profit from the business sector to the household sector or the factory owners as a monetary reward for their factor services. Corresponding to this, money flows as consumption expenditure when household sector purchases goods and services from the business firms.
In macroeconomics, a circular flow model can be classified into three categories depending upon their field of scope as given below.
1. Two-Sector Model
The circular flow model in the two-sector economy is a hypothetical concept which consists of only two aspects, household and business sector. The state of equilibrium in the two-sector economy is defined as a situation in which no change occurs in the levels of income (Y), expenditure (E), and output (O).
This means that the expenses made by the households become the source of income for the business entities. The entities transfer the income to the factor owners to attain the factors of production. Further, the factor owners spend this income on goods and services produced by the business entities. This leads to a circular movement of income and expenditure in the economy.
2. Three-Sector Model
The three sector model describes the economy with the inclusion of the government sector along with household and business sectors. Here, the source of income for the government is in the form of taxes, subsidies and transfer payments made by the households and business firms.
3. Four Sector Model
The four sector model is a modern monetary economy that comprises of household, business sectors, government, and foreign sectors. Each of the sectors in the economy receives payment in one form or another. Money acts as an exchange tool for the smooth transfer of goods and services among the international markets. The residual amount from the transaction flows into the capital market as savings which are further used as investments for business firms and government sector.
4. Five Sector Model
The five sector model comprises of leakages and injections that occur in the economy and is a more realistic representation of the economy. The leakages comprise of savings (S), taxes (T), and imports (M), whereas, the injections comprise of investment (I), government spending (G), and exports (X).
The model states that equilibrium occurs when the total leakages are equal to the total injections that occur in the economy.
i.e. S+T+M= I+G+X