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8/12/2019 Circular Flow of Income Dr M Manjunath Shettigar
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Circular Flow of Income
8/12/2019 Circular Flow of Income Dr M Manjunath Shettigar
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Circular Flow of Income
This is a simple economic model which describes
the flow of income between producers and
consumers (Firms & House holds) in a circular
mode It highlights the interdependence of goods markets
and factor markets
It is the relationship between production and
consumption
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Householdsa household is defined as a small
group of persons who share thesame living accommodation, who
pool their income and wealth and
who consume certain types of goods
and services collectively (mainlyhousing and food)
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AssumptionsThe basic circular flow of income model consistsof six 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 isno saving (S).
All output(O) produced by firms is purchased byhouseholds through their expenditure (E).
There is no financial sector.
There is no government sector.
There is no external sector.
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The circle of money flowing through theeconomy is as follows: total income is spent(with the exception of "leakages" such asconsumer saving)
while that expenditure allows the sale ofgoods and services, which in turn allows thepayment of income (such as wages andsalaries).
Expenditure based on borrowings andexisting wealth
i.e., "injections" such asfixed investment can add to total spending.
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Labor and other factors of production are sold on
resource market and goods and services are sold
on the product market
If there are no leakages it would be Y=E=O
Leakages are savings, Taxes, Imports
Injections are Investment, Govt. spending, Exports
Although leakages may eventually finance theinjections, they do not cause them
So in an open economy there can be three
gaps/imbalances
i) investment-savingsii) Fiscal deficit/surplus
iii) current Account(BOP) deficit/surplus
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Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
The circular flow of income
Firms
Households9
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Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
Investment (I)
Government
expenditure (G)
Export
expenditure (X)
Financial
system,
(BANKS,
etc.)
Net
saving (S)
GOV.
Nettaxes (T)
ABROAD
Import
expenditure (M)
The circular flow of income
LEAKAGES
INJECTIONS
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5 sector model of the economy
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The interdependence of goods and factor
markets
Q1
P1
QF2
PF2
Q2
P2PF1
QF1
D2D2
P
Q
P
Q
Factor
services
Goods
GoodsFactor
services
S S
D1 D1
(1)
Consumerdemand
(4)
Factor
supply
(3)
Factor
demand
(2)
Producer
supply
OO
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