What is Circular Flow In Economics? 3 Models of Circular Flow

What is Circular Flow in Economics?

Circular Flow in Economics means the circular flow of money and spending in the economy. At simplest level circular flow of money contains two elements such as income workers get money (or money flows to workers) in the form of wages or salaries and money flows back to the firm in exchange of products produced by it. An economy is made up of numerous circular flows of income.

People go to work to earn money and that earned money is used to buy various goods and services from various businesses like clothes, food, basic commodities, rent, health & wellness products, entertainment services etc. The exchange of money between firms and workers is known as a circular flow of income in an economy. Companies manufacture goods and provide services to their consumers. They require labor, land, and capital to increase their sales and profits.

They pay wages or salaries to hired labor which is called income. Hence, that income earned by these people is used to buy goods and services for household or other purposes from these businesses.

In this way, businesses use the income earned from selling goods and services to enhance their business which requires more labor hence, the circle of income goes on in the economy. It is important for an economy that money should not get hoarded and keep flowing to sustain a firm level of economic activities and income.

By reducing, different economic units of a country in homogeneous groups, a clear outline of a relation between them can be established. For instance, all activities related to the household can be grouped together and can be considered one unit and government agencies and various enterprises can be grouped as one unit.

These groups are interlinked with one another through various economic activities like production, consumption, and capital formation etc. The expenditure of a firm is income for labors, workers, and resource owners and the money spent by consumers is income to firms. Therefore, we can say that more expenditure ensures more income and more production.

The circular flow of income not only takes place in two sectors closed economy, but it also takes place in three sector economy as well as the four-sector open economy in which foreign trade transactions are also considered. Let us understand these different circular sectors in detail.

Models of Circular Flow in Economics

1) Two Sector Model :

In this model, two sectors of a simple economy are considered, one is the household sector and another is the business sector which includes firms. Household decides both economic resources and factors of production. These resources can be labor force or capital stock or both. Only families are not considered household. However, communal groups and single people are also considered a household in a two-sector model.

The members of the household also decide the factors of production. Whereas, the business sector hires employees and use resources and produce goods. Business and firms obtain economic resources from household and in return provide goods and services to them. This is known as real flow. Exchange of goods can itself be known as barter, however, it would be very inconvenient.

Therefore, money is used as a medium of exchange. Business sector spends money to purchase resources for the purpose of production from the resource market and receive money back by selling goods and services supplied through the product market. the business sector has to pay to obtain factor services which incur “factor costs” to them get to receive it back through income. To maintain equilibrium between two sectors it is important that the flow of money between in opposite direction should match.

Followings are the few assumptions made in the two-sector model.

1. Only business sector produces goods and services.
2. It is a closed economy that means no foreign trade sector is part of the economy flow.
3. All income by families is spent on consumption which means that there are zero savings in the household.
4. All goods and services produced in the business sector are sold, which means there is no inventory stored in the business sector.
5. There are no other expenditures like taxes involved in this model.

According to the above assumptions, production should be equal to sales and income should be equal to expenditure, only then the circular flow will be complete. It is not possible to uphold these assumptions in the real world and most of the times these required to be dropped. Hence, the circular flow becomes a little complicated in the economy. The real economic flow adds complications.

These complications are triggered by injections and leakage. Factors which increase the spending is called injections and factors which reduces spending is called leakage. However, the basic mechanism of circular flow doesn’t change with making small adjustments in the transactions.

2) Three-Sector Model :

Three sector model involves the government of an economy in the circular flow of economic activities. The government spends to produce goods and activities and get back money in the form of taxes. These taxes are an important source of leakage other than savings. And the goods and services purchased by the government is an important source of injection. Money paid to government limits the spending of a household. However, the government can balance the effect of the by using that money to spend on the purchase of more goods and services.

This action, where government levies taxes and use the money gathered in the form of taxes to spending more to purchase goods and services is known as fiscal action. In this model, if household pay says 1000 rupees as the tax to the government that means the consumption, as well as saving of the household, will reduce. This will further impact the sales of the business. however, in this model, there is a new source of injection “government” which will balance the effects of tax leakage by purchasing and spending.

3) Four Sector Model :

The two-sector model and three-sector model are closed, economic model. There is another model known as the third sector open model. This model also includes a fourth sector called “foreign trade” where transactions taking place in the foreign trade sector is also a part of this model. The purchase made by household in abroad and brings goods in the economy represents the leakage of money from the circular flow.

This leakage is important to be balanced.  The injection in circular flow increases when foreign tourists purchased domestic goods and services. In the four-sector model, imports are treated as leakage and exports are treated as an injection. However, only imports are not the only leakage in this model but savings and taxes are also considered leakage, similarly, investments and government expenditure are also considered injection along with exports.