THE CIRCULAR FLOW OF INCOME Dr. SK LAROIYA UNIV OF DELHI AND AMITY BUSINESS SCHOOL

TO UNDERSTAND THE METHODS OF MEASURING NATIONAL INCOME IT IS NECESSARY TO SIMPLIFY THE COMPLEX NET WORK OF NUMEROUS TRANSACTIONS CONDUCTED IN A MODERN ECONOMY

A SIMPLIFIED MODEL OF AN ECONOMY CAN BE CONSTRUCTED IN WHICH ALL TRANSACTIONS ARE CLASSIFIED IN A FEW BROAD CATEGORIES DERIVED SPECIFICALLY FOR MEASURING NATIONAL INCOME

SUCH A MODEL WITH ITS VARIANTS, WOULD REPRESENT OVERALL ECONOMIC ACTIVITY IN THE FORM OF WHAT MAY BE CALLED ‘THE CIRCULAR FLOW OF INCOME’

WITH THESE MODELS WE CAN DEMONSTRATE MACRO ECONOMIC EQUILIBRIUM, SO VITAL FOR THE ECONOMIC POLICY FORMULATION AND ITS EFFECTIVE IMPLEMENTATION

FOUR MODELS: 1.BASIC MODEL 2.WITH SAVINGS AND INVESTMENTS 3.WITH GOVERNMENT 4.WITH FOREIGN TRADE

BASIC MODEL Supply of goods and services Household sector Business sector Payment of factor incomes: wages, interest, rent and profit Factor services: lab.,land, capital, enterprise Expenditure on goods and services

ASSUMPTIONS: 1.ONLY TWO SECTORS IN THE ECONOMY: BUSINESS AND HOUSEHOLD SECTORS 2.HOUSEHOLD SECTOR SPENDS ALL THE MONEY IT RECEIVES 3.ALL THE INCOME OF BUSINESS SECTOR IS EXHAUSTED IN MAKING FACTOR PAYMENTS 4.HOUSEHOLD AND BUSINESS SECTOR DO NOT SAVE ANY MONEY AND PAY NO TAXES 5.IT IS A CLOSED ECONOMY

WITHDRAWAL: A WITHDRAWAL CONSISTS OF ANY PART OF INCOME GENERATED IN PRODUCING NATIONAL PRODUCT WHICH IS PASSED ON WITH IN THE ECONOMY

1.SAVINGS 2.IMPORTS 3.TAXES

INJECTION: AN INJECTION IS AN ADDITION TO THE CIRCULAR FLOW OF INCOME

1.INVESTMENT 2.EXPORTS 3.SUBSIDIES 4.GOVERNMENT EXPENDITURE 5.TRANSFER PAYMENTS

Supply of goods and services Household sector Business sector Payment of factor incomes: wages, interest, rent and profit Factor services: lab.,land, capital, enterprise Expenditure on goods and services --- withdrawals + injections - withdrawals + injections

MODEL WITH SAVINGS AND INVESTMENTS Supply of goods and services Household sector Business sector Payment of factor incomes: wages, interest, rent and profit Factor services: lab.,land, capital, enterprise Expenditure on goods and services --- Bus. savings + Investments - HH. savings + injections

National income= C + S S= S H +S B S H = household savings S B = busines savings National product= C + I For Equilibrium: Y=C + S Y= C + I S= I

MODEL WITH GOVT. SECTOR Supply of goods and services Household sector Business sector Payment of factor incomes: wages, interest, rent and profit Factor services: lab.,land, capital, enterprise Expenditure on goods and services --- Bus. savings + Investments - HH. savings + injections -- Taxation +Govt. exp. Inc. subsidies

Y= C+S+T Y= C+I+G T=TAXES G=GOVT. EXPENDITURE Y=C+I+G FOR EQUILIBRIUM C+I+T=C+I+G S+T=I+G S+(T-G)=I

MODEL WITH FOREIGN TRADE SECTOR Supply of goods and services Household sector Business sector Payment of factor incomes: wages, interest, rent and profit Factor services: lab.,land, capital, enterprise Expenditure on goods and services --- Bus. savings + Investments - HH. savings + injections -- Taxation - Imorts +Exports +Govt. exp. Inc. subsidies

Y=C+S+T+M Y=C+I+G+X FOR EQUILIBRIUM C+S+T+M=C+I+G+X S+T+M=I+G+X S+T=I+G+(X-M) X-M IS NET FOREIGN INVESTMENT.

PUTTING IF FOR X-M AND ID FOR DOMESTIC INV. WE HAVE S+T= ID+G+IF S+(T-G)=ID+IF SO IN FOUR SECTOR MODEL WE HAVE S+(T-G)=ID+(X-M)