Circular Flow of Income: 2 Sector, 3 Sector and 4 Sector Economy

Circular Income Flow in a Two Sector Economy:

Real flows of resources, goods and services have been shown in Fig. 6.1. In the upper loop of
this figure, the resources such as land, capital and entrepreneurial ability flow from households to
business firms as indicated by the arrow mark.
In opposite direction to this, money flows from business firms to the households as factor
payments such as wages, rent, interest and profits.

In the lower part of the figure, money flows from households to firms as consumption
expenditure made by the households on the goods and services produced by the firms, while the
flow of goods and services is in opposite direction from business firms to households.
Thus we see that money flows from business firms to households as factor payments and then it
flows from households to firms. Thus there is, in fact, a circular flow of money or income. This
circular flow of money will continue indefinitely week by week and year by year. This is how
the economy functions. It may, however, be pointed out that this flow of money income will not
always remain the same in volume.
In other words, the flow of money income will not always continue at a constant level. In year of
depression, the circular flow of money income will contract, i.e., will become lesser in volume,
and in years of prosperity it will expand, i.e., will become greater in volume.
This is so because the flow of money is a measure of national income and will, therefore, change
with changes in the national income. In year of depression, when national income is low, the
volume of the flow of money will be small and in years of prosperity when the level of national
income is quite high, the flow of money will be large.
Circular Income Flow with Saving and Investment:
In our above analysis of the circular flow of income we have assumed that all income which the
households receive, they spend it on consumer goods and services. A result, circular flow of
money speeding and income remains undiminished. We will now explain if households save a
part of their income, how their savings will affect money flows in the economy.
When households save, their expenditure on goods and services will decline to that extent and as
a result money flow to the business firms will contract. 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.
This will lead to the fall in total incomes of the households. Thus, savings reduce the flow of
money expenditure to the business firms and will cause a fall in economy’s total income.
Economists therefore call savings a leakage from the money expenditure flow.
But savings by households need not lead to reduced aggregate spending and income if they find
their way back into flow of expenditure. In free market economies there exists a set of
institutions such as banks, insurance companies, financial houses, stock markets where
households deposit their savings. All these institutions together are called financial institutions or
financial market. We assume that all the savings of households come in the financial market. We
further assume that there are no inter-households borrowings.
It is business firms who borrow from the financial market for investment in capital goods such as
machines, factories, tools and instruments, trucks. Firms spend on investment in order to expand
their productive capacity in future.
Thus, through investment expenditure by borrowing the savings of the households deposited in
financial market, are again brought into the expenditure stream and as a result total flow of
spending does not decrease. Circular money flow with saving and investment is illustrated in Fig.
6.2 where in the middle part a box representing financial market is drawn. Money flow of
savings is shown from the households towards the financial market. Then flow of investment
expenditure is shown as borrowing by business firms from the financial market.

Saving-Investment Identity in National Income Accounts in a Two Sector Economy:

Despite the fact that people who save are different from the business firms which primarily
invest, in national income accounts savings are identical or always equal to investment in a
simple two sector economy having no roles of Government and foreign trade. This is a basic
identity in national income accounts which needs to be carefully understood.
Of course, in our above analysis of circular flow of income, we explained that planned
investment by business firms can differ from savings by household. But in that analysis we
referred to planned or intended investment and savings which often differ and affect the flow of
national income.
However, in national income accounts we are concerned with actual saving and actual
investment. It is these actual or realised saving and investment that are identical in national
income accounts. We can prove their identity in the following way.
In a simple economy which has neither government, nor foreign trade, the value of output
produced which we denote by Y is equal to the value of output sold. Since the value of output
sold in a simple two sector economy is equal to the sum of consumption expenditure and
investment expenditure we have y= C+ I where Y = Value of aggregate output, C =
Consumption expenditure and I = Investment expenditure.
A pertinent question which arises here is what happens to the unsold output. The unsold output
leads to the increase in the inventories of goods and in national income accounting increase in
inventories of goods is treated as a part of actual investment. This may be considered as the firms
selling the goods to themselves to add to their inventories. Thus, gross national product (GNP)
produced is used either for consumption or for investment.
Now, look at the gross national product or income in the simple economy from the viewpoint of
its allocation between consumption and saving. Since national income (which is equal to GNP)
can be either consumed or saved,. We have Y Ξ C+ S
From the identities (i) and (ii) we get
C+ I Ξ Y Ξ C+ S
The left hand side of the identity (iii), namely C + I = Y shows the components of aggregate
demand (that is, aggregate expenditure on goods and services produced) and the right-hand side
of the identity (iii) namely Y = C + S shows the allocation of national income to either
consumption or saving. Thus, the identity (iii) shows that the value of output produced or sold is
equal to the total income received. It is income received that is spent on goods and services
produced.
Now subtracting the consumption (C) from both sides of the identity (iii) we have
IΞYΞS
or I = S
Thus, in our two sector simple economy with neither government, nor foreign trade, investment
is identically equal to saving.
Circular Income Flow in a Three Sector Economy with Government:
Government purchases goods and services just as households and firms do. Government
expenditure takes many forms including spending on capital goods and infrastructure (highways,
power, communication), on defence goods, and on education and public health and so on. These
add to the money flows which are shown in Fig. 6.3 where a box representing Government has
been drawn. It will be seen that government purchases of goods and services from firms and
households are shown as flow of money spending on goods and services.
Government expenditure may be financed through taxes, out of assets or by borrowing. The
money flow from households and business firms to the government is labelled as tax payments in
Fig. 6.3 This money flow includes all the tax payments made by households less transfer
payments received from the Government. Transfer payments are treated as negative tax
payments.
Another method of financing Government expenditure is borrowing from the financial market.
This can be represented by the money flow from the financial market to the Government and is
labelled as Government borrowing (To avoid confusion we have not drawn this money flow
from financial market to the Government). Government borrowing increases the demand for
credit which causes rate of interest to rise.
The government borrowing through its effect on the rate of interest affects the behaviour of firms
and households. Business firms consider the interest rate as cost of borrowing and the rise in the
interest rate as a result of borrowing by the Government lowers private investment. However,
households who view the rate of interest as return on savings feel encouraged to save more.
It follows from above that the inclusion of the Government sector significantly affects the overall
economic situation. Total expenditure flow in the economy is now the sum of consumption
expenditure (denoted by C), investment expenditure (I) and Government expenditure (denoted by
G). Thus
Total expenditure (E) = C + I + G …..(i)
Total income (K) received is allocated to consumption (C), savings (S) and taxes (T). Thus
Y = C + S + T … (ii)
Since expenditure) made must be equal to the income received (Y), from equations (i) and (ii)
above we have
C + I + G = C + S + T … (iii)
Since C occurs on both sides of the equation (iii) and will therefore be cancelled out, we have
I + G = S + T …(iv)
By rearranging we obtain
G – T = S – I … (v)
Equation (v) is very significant as it depicts what would be the consequences if government
budget is not balanced, that is, if Government expenditure (G) is greater than the tax revenue (7),
that is, G >T, the government will have a deficit budget. To finance the deficit budget, the
Government will borrow from the financial market.
For this purpose, then private investment by business firms must be less than the savings of the
households. Thus Government borrowing reduces private investment in the economy. In other
words, Government borrowing crowds out private investment.
Money Income Flows in the Four Sector Open Economy: Adding Foreign Sector:
We now turn to explain the money flows that are generated in an open economy, that is,
economy which have trade relations with foreign countries. Thus, the inclusion of the foreign
sector will reveal to us the interaction of the domestic economy with foreign countries.
Foreigners interact with the domestic firms and households through exports and imports of goods
and services as well as through borrowing and lending operations through financial market.
Goods and services produced within the domestic territory which are sold to the foreigners are
called exports.
On the other hand, purchases of foreign-made goods and services by domestic households are
called imports. Figure 6.4 illustrates additional money flows that occur in the open economy
when exports and imports also exist in the economy. In our analysis, we assume it is only the
business firms of the domestic economy that interact with foreign countries and therefore export
and import goods and services.

A flow of money spending on imports have been shown to be occurring from the domestic
business firms to the foreign countries (i.e., rest of the world). On the contrary, flow of money
expenditure on exports of a domestic economy has been shown to be taking place from foreign
countries to the business firms of the domestic economy.
If exports are equal to the imports, then there exists a balance of trade. Generally, exports and
imports are not equal to each other. If value of exports exceeds the value of imports, trade
surplus occurs. On the other hand if value of imports exceeds value of exports of a country, trade
deficit occurs.
In the open economy there is interaction between countries not only through exports and imports
of goods and services but also through borrowing and lending funds or what is also called
financial market. These days financial markets around the world have become well integrated.
When there is a trade surplus in the economy, that is, when exports (X) exceed imports (M), net
capital inflow will take place. By net capital inflow we mean foreigners will borrow from
domestic savers to finance their purchases of domestic exports. In this way as a result of net
capital inflow domestic savers will lend to foreigners, that is, acquire foreign financial assets.
On the contrary, in case of import surplus, that is, when imports are greater than exports, trade
deficit will occur. Therefore, in case of trade deficit, domestic consumer households and business
firms will borrow from abroad to finance their excess of imports over exports. As a result,
foreigners will acquire domestic financial assets.
From the circular flows that occur in the open economy the national income must be measured
by aggregate expenditure that includes net exports, that is, X-M where X represents exports and
M represents imports. Imports must be subtracted from the total expenditure on foreign produced
goods and services to get the value of net exports. Thus, in the open economy
National Income = C + I + G + NX
where NX represents net exports, X-M.
Since national income can be either consumed, saved or paid as taxes to the Government we
have
C + I + G + NX = C + S + T