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 UNIT: IV

Circular Flow of Income

• Two Sector model

• Three sector model

• Four Sector model

 Learning Outcome

• How the circular flow takes place?

• Knowledge about what are the injections

and leakages in the economy.
 Let’s recall

1. Differentiate between internal and

external environment that affects the
decision making of business.
 Per Capital Income and
Personal Income
❖ Per capita income is the average income of the people of a country in a
particular year.
National Income
Per Capita Income =
Total Population

❖ Personal income is the total income received by the

individuals of a country from all sources before direct
taxes in one year.
Personal Income = National Income –Undistributed Corporate Profits
– Corporate Taxes – Social Security Contributions + Transfer
Payments + Interest on Public Debt
❖ Personal Disposable Income is the income which can be
spent on consumption by individuals and families.
Personal Disposable Income = Personal Income – Personal Taxes
 Real GDP and Nominal GDP

❖ Nominal GDP = National income estimated at the prevailing prices is

called nominal GDP.
❖ Real GDP=National income measured on the basis of some fixed
price, say price prevailing at a particular point of time, or by taking a
base year, is known as national income at constant prices, or Real
GDP

Nominal GDP
GDP Deflator = x100
Real GDP

❖GDP deflator is the ratio of nominal GDP in a year to real GDP of that
year
❖GDP deflator measures the change in prices between the base year and
the current year.
 ?
How far national income of a country a
measure of welfare?
 ?
❖ What is the Difference between GDP
and GNP?
❖ Whether unemployment allowance
from the government is to be included
in the national income. Why or Why
not?
❖ Will the transfer payment be a part of
GDP or personal income ?
 GDP and Economic
Well-Being
❖ GDP is the best single measure of the
economic well-being of a society.
❖ GDP per person tells us the income and
expenditure of the average person in the
economy.
 GDP and Economic
Well-Being

❖ Higher GDP per person indicates a higher

standard of living.
❖ GDP is not a perfect measure of the
happiness or quality of life, however.
 GDP and Economic
Well-Being

❖ Some things that contribute to well-being are not

included in GDP.
The value of leisure.
The value of a clean environment.
The value of almost all activity that takes place
outside of markets, such as the value of the
time parents spend with their children and the
value of volunteer work.
 Methods of measuring national
income
❖ Product (or Output) Method
❖ Income Method
❖ Expenditure Method
 Product (or Output) Method
❖ The market value of all the goods and services produced
in the country by all the firms across all industries are
added up together.
❖ Process
– The economy is divided on basis of industries, such as
agriculture, fishing, mining and quarrying, large scale
manufacturing, small scale manufacturing, electricity, gas, etc.
– The physical units of output are interpreted in money terms
– The total values added up. (GDP at market price)
– The indirect taxes are subtracted and the subsidies are added.
(GDP at factor cost)
– Net value is calculated by subtracting depreciation from the total
value (NDP at factor cost).
 Product (or Output) Method
❖ Product method is also called Value Added Method or
Industrial Origin Method

❖ The market value of all the goods and services produced

in the country by all the firms across all industries are
added up together.
 Steps of Value Added or Product Method:

Step 1 : Identification and Classification of

Producing Enterprises

a) Primary Sector: refers to that sector

wherein goods are produced by
exploiting natural resources
b). Secondary Sector: This sector is also called
manufacturing sector. Enterprises of this sector
transform one type of good into another type.

c) Tertiary Sector: provides services and so is

called service sector. It includes trade, hotels,
transport and communication, financing,
insurance. Service alone are provided by this
sector. Public administration and defence and
 Step 2: Estimation of Value Added

• Value added is the difference between

value of output of an enterprise and the
value of its intermediate consumption
(non-factor inputs).

• Value added = Value of output- Value of

non-factor input
 Value added may be of the following
kinds:
1. Gross Value added at Market Price: Gross value added is
the difference between value of output and intermediate
goods. Gross domestic value added is equal to gross
domestic product at market price.

2. Net Value Added at Market Price

3. Net Value Added at Factor Cost

• Estimating net factor income from abroad which is added to
domestic income for deriving
• national income.
 Estimating
Value Added
Item Value of Cost of Value
Producing Output (Rs) Intermediat Added
Enterprise e Goods
Farmer 600 200 400
Flour Mill 800 600 200
Baker 1000 800 200
Shopkeeper 1200 1000 200
Total 3600 2600 1000
Limitations of Product Method
❖ Problem of Double Counting:
– unclear distinction between a final and an intermediate
product.
❖ Not Applicable to Tertiary Sector:
– This method is useful only when output can be measured
in physical terms
❖ Exclusion of Non Marketed Products
– E.g. outcome of hobby or self consumption
❖ Self Consumption of Output
– Producer may consume a part of his production.
Limitations of Product Method
❖ Problem of Double Counting:
– unclear distinction between a final and an intermediate
product.
❖ Not Applicable to Tertiary Sector:
– This method is useful only when output can be measured
in physical terms
❖ Exclusion of Non Marketed Products
– E.g. outcome of hobby or self consumption
❖ Self Consumption of Output
– Producer may consume a part of his production.
Circular Flow of Income
The simple model of the circular flow assumes two players:

1. Firms

2. Households

Firms

• Produce and supply the goods and services.

• Require various factors of production to produce these goods

and services.
Households

• Include a set of individuals living in the same house

• Provide services in terms of factor inputs to the firms

• Get paid for these services by firms which households spend on

consumption.

• Money flows from firms to households as factor payments and from

households to firms as expenditure on goods and services.

• It is a circular flow of money or income

• Money flow and real flow are the two main
aspects of the circular flow of income
economic model.

• Real flows refer to the flow of the actual

goods or services, while money flows refer
to the payments for the services (wages, for
example) or consumption payments.
 Circular Flow of Income
(Two Sector Economy)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)
Factor Inputs

Financial
Households Savings Market Investment Firms
(S) (I)

Goods and
Services (O)

Consumption
expenditure
(C)
Circular Flow in Three Sector
Economy
• In three-sector economy there are three
parties:

a) Household

b) Firms

c) Government
Here, there are two important components:

a. Injection: Injections are types of

expenditure on goods and services that
have any origin other than the household
consumption.
 Can you give examples of
injections into the economy?
1. Government purchases

2. Transfer payments

3. Investment
b. Leakage: Instead of spending all of the
income immediately on consumption, part of
household income “leaks out” from the
economy, which is called leakage.
 Can you give examples of
leakages into the economy?
1. Savings

2. Taxes

3. Investment
Polling question
Closed economy is an economy where:

a. There exists trade relations with rest of

the world.
b. There do not exist any trade relations with
rest of the world.
c. Both (a) and (b).

d. None of the above.

Circular Flow in Four Sector
Economy
• The circular flow model in four sector
economy provides a realistic picture of the
circular flow in an economy.
• The four sector economy comprises of:
a)Household

b)Firms

c)Government

d)Foreign Sector
 Circular Flow of Income
(Four Sector Economy)
Government
(G)
Taxes
Taxes
Factor
Payments Remittances
for purchases
Factor Inputs
Salaries

Savings
(S) Financial Market Firms
Households Investment
(I)
Imports Imports
Goods (M)
(M) (O)
Consumption
Expenditure

Foreign Nations Exports

Exports (X-M) (X)
(X)
National Income=C+I+G+(X-M)
 Injections and Leakages from
Circular Flow
Injections Leakages
• Savings • Investment

• Taxes • Government Spending

• Imports • Exports
Polling question
Savings and imports constitute ________
to/from the circular flow:

a. injections
b. leakages
c. Both (a) and (b)

d. None of the above