Circular Flow Model Definition and Calculation

The circular flow in a three-sector economy is illustrated in Figure 11. It removes its defects by regulating the activities of the private sector and by providing incentives to it. The government also uses resources to produce goods and services itself which are sold to households and firms. These decision-making agents take economic decisions to produce goods and services and to exchange them in order to consume them for satisfying the wants of the whole economy. The development of today’s circular flow model is attributed to the American economist Frank Knight (1885–1972). Knight called the diagram “the wheel of wealth,” and he used it as a teaching aide in his classes at the University of Iowa as early as the 1920s.

1. After adding in governments, investors, and foreign markets, the circular flow model depicts how cashflow moves money from one sector to the next in a systematic, organized way.
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3. This circular flow of economic activity is maintained not only in two sector closed simple economy but also in three sector economy and four sector open economy in which we take into consideration the foreign trade sector transactions.
4. Keynes was the first to note the fact of the circular flow of economic activity.
5. Labor markets are the most commonly discussed form of a factor market, but it’s important to remember that factors of production can take many forms.

So far the circular flow has been shown in the case of a closed economy. But the actual economy is an open one where foreign trade plays an important role. These are the real flows of goods and services from firms to consumers which are linked with productive resources from consumers to firms through the medium of exchange or barter. When factor markets are put together with goods and services markets, a closed loop for the flow of money is formed. As a result, continued economic activity is sustainable in the long run, since neither firms nor households are going to end up with all of the money. Broadly defined, this is a foreign investment that enters the system – enriching the economy.

What is the Circular Flow Model?

For instance, the relationship between a government’s taxation policies and a household’s consumption spending will have a direct impact on a business’s ability to sell goods. Goods and services produced by the business sector are purchased by households. Household creates savings in an economy and they are pay taxes to the government. This act on the part of the government to levy taxes and to spend more is called fiscal action. The working of the three sector model involving government transactions, taxes and expenditure is shown in the model given in Fig.

Four Sector Circular Flow Model

Consumer goods are products that are intended for use by individuals, such as shoes, backpacks, cars, or computer. While capital goods are items that are manufactured to produce other goods and services, such as a bulldozer used to clear land for homes, school computers for students, or a cash register at a grocery store. Writing paper, food products, and gasoline are considered non-durable goods since they do not last for longer than six months when used regularly. Televisions, refrigerators, or tables are durable goods because they will last three or more years when used on a regular basis. Instead, it describes the current position of an economy regarding how its inflows and outflows are used.

Three-sector model

For all exports of goods, the government receives payments from abroad. If government purchase exceeds net taxes then the government will incur a deficit equal to the difference between the two, i.e., government expenditure and taxes. The government finances its deficit by borrowing from the capital market which receives funds from the household sector in the form of saving. The expenditure of firms in buying productive resources in the factor market from the consumers becomes the incomes of households, which is shown in the outer circle of the upper portion from left to right in the diagram.

The Circular Flow of Economic Activity

In its capacity, it is obligated to provide public services to both companies and households with the funds it raises via tax collection from citizens and businesses. The circular flow model is an economic model that presents how money, goods, and services move between sectors in an economic system. The flows of money between the sectors are also tracked to measure a country’s national income https://1investing.in/ or GDP, so the model is also known as the circular flow of income. Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues.

As shown in the figure, taxes flow from the household and business sectors to the government. There the government purchases goods from companies and factors of production from households. In this model we see that business and household sectors are the principals in the circular flow of real items and money—that takes place in the resource and product markets.

The government plays a key role in all types of economic systems—capitalist, socialist and mixed. They may be single-individuals or group of consumers taking a joint decision regarding consumption. Their ultimate aim is to satisfy the wants of their members with their limited budgets. The role of the government theoretically extends to the provision of public services.

Exporting goods is a prominent injection as it brings more money into circulation. It is pertinent to note that exports are injections and not government taxes. A taxes payment is not an injection in that it is not outside money that enters the system. It falls under other money that moves around the system (from companies and households to the government).

In terms of the circular flow of income model, the leakage that financial institutions provide in the economy is the option for households to save their money. This is a leakage because the saved money cannot be circular flow of economic activity spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector.

In this example, we’ll also include the government to form a three-sector circular flow model. When G + X + I is greater than T + M + S, the level of national income (GDP) will increase. When the total leakage is greater than the total injected into the circular flow, national income will decrease. As long as a country’s injections is greater than its leakages, a country’s economy can theoretically remain sustaining forever. However, if there are cash flow shortages (i.e. leakages), the country must find additional cash flow to compensate for the shortage. There are different types of circular flow models, each with a different number of sectors it tracks.

The model also does not account for situations in which the levels of supply and demand fluctuate. Prices may be changed for reasons other than the natural functioning of market forces. For example, if consumer tastes shift, levels of demand would change, causing prices to change.

Circular Flow Model

Companies use the production factors they receive from households to produce goods and services they sell to households for money. Companies can use this income to grow, and households can purchase these goods and services to develop or satisfy their needs. The two-sector model assumes that there is no government involvement, so there are no taxes or public services & goods provided. The money flows from the household (as an expenditure to the household) to the businesses and back when the households purchase the goods & services (reflected by the green arrow in Figure 1) provided by the firms.

The financial sector includes household savings, which are invested back into the economy. There is an import and export of goods & services, as well as foreign exchange as inflow & outflow of capital, occur for the same. Government maintains national security, law and order and provides public goods, welfare goods and services to the public from tax revenue collected from the government. Total Output should be the same as Total Income and Total Expenditure.

Government taxes leak out of the circular flow model, and then government spending injects them back into the economy. Imports leak out of the economy because the money in our country that’s used to buy imports from other countries goes out of our economy and into their hands. Exports, on the other hand, are an injection because we earn income from the goods and services we export to other countries. The circular flow model’s different sectors and models help maintain equilibrium in an economy. In a two-sector model, investments must equal savings to achieve this balance.