The circular flow of income
circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents The flows of money and goods exchanges in a closed circuit and correspond in value, but run in the opposite direction.
The circular flow analysis is the basis of national accounts and hence of macroeconomics.
The circular flow of income refers to the flow of payments and receipts for factor services and for currently produced output passing between domestic firms and households.
Circular flow of income describes the flow of payments from businesses to households in exchange for labor and other productive services and the return flow of payment s from household to businesses in exchange for goods and services.
The points below should be noted:
- For easy understanding, a two sector economy which involves households and firms will be used. The household supply factors of production (input) to firms which need them for production purposes.
- In return the household will be paid salaries and wages, interest, rents by the firms which constitute their incomes.
- The Income is then used by the households to purchase goods and services produced by the firms. This pattern of consumption expenditure made by households constitutes income for a firm which leads to the formation of income inflow.
Factors Affecting Circular Flow of Income
- Injection: Injection of fund into the circle is an increase in the incomes of households and firms beside their normal processes of selling productive resources and manufactured goods.
- Savings: Savings constitute the part of income that is not spent immediately. They have the tendency of reducing expenditure of the household or firms.
- Withdrawal: Withdrawal has the tendency of reducing the fund in the circular flow of income.
- Investment: investment brings about an additional income leading to injection into the circular flow of income.
- Aids and grants: Aids and grants from government or other sources increase the volume of fund in the circular flow of income.
- Import and Export: While import involves the expenditure on foreign goods and services leading to withdrawals from circular flow of income, exports provide funds leading to injection into the circular flow of income.
Concept of consumption
Consumption can be defined as the total quantity of goods and services purchased and used by consumers during a specific period of time.
Consumption can be defined as the expenditure on goods and services at a given period of time. It is the expression of total consumer demand.
Types of consumption
- Durable Goods: This involves consumption expenditure on certain items which are durable in nature, e.g houses, motor vehicles, furniture etc.
- Non Durable Goods: This involves consumption expenditure on goods that are not durable in nature e.g food, clothing, water etc.
- Services: This involves consumption expenditure on general services, e.g. legal fees, entertainment fees, educational fees etc.
Factors that determine the level of consumption
- Level of income
- Interest rate
- Rate of taxation
- Profit earned
- Possession of assets
- Future expectation
Test and Exercise
- The circular flow of income is (a) the means by which money in circulation turns around (b) the level of people money flows to (c) It is the receipts for the payment o for services
- The total quantity of goods and services purchased and used by consumers during a specific period is (a) savings (b) consumption (c) savings (d) income.
- All of the following are factors that affects the flow of income except (a) injection (b) withdrawal (c) stagnancy (d) investment
- The circular flow of income majorly is concerned with (a) how money is circulated (b) how money is spent (c) how money is save (d) has nothing to do with money.
- All are types of consumption except (a) services (b) durable goods (c) non durable goods (d) immediate goods. For previous lesson on Elementary Theory Of Income Determination visit https://passnownow.com/namaste-lesson/elementary-theory-income-determination-2
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