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Overview
Ô Introduction
Ô The two sector model
Ô The three sector model
Ô The four sector model
Introduction
Ô In economics, the term circular flow of income or circular
flow of economic activity refers to a simple economic
model which describes the circulation/flow of income
between producers and consumers
Ô x
Ô
Ô
Ô
xouseholds:
It is a person or a group of people that share their income.
The members of households have two functions:
Ôthey supply different factors of production
Ômembers of household also work as consumers
Úirms:
An organization that produces goods and services for sale.
Regarded as the economic units whose main objective is to
maximize profit in the production process. The three main
functions are as follows:
Produce goods and services and supply them in the
market.
Úirms purchase inputs or raw materials from households to
use them in the production process.
Government:
Just like households and firms the government also earns
incomes and makes expenses. Two major functions played
are:
Government earns revenue either from tax or non-tax
sources both from households and firms.
Ô Government provides essential public services such as
maintenance of law and order, defense services,
judiciary etc
Úoreign Market:
It consists of two kinds of international economic
transactions i.e. export and import of goods and services
and inflow and outflow of capital.
Úinancial Institution :
Ô consists of banks and non-bank intermediaries who
engage in the borrowing (savings from households)
and lending of money.
Ô the leakage that financial institutions provide in the
economy is the option for households to save their
money.
Two Sector Model
Assumptions
xouseholds:
Ô To own all the factors of production
Ô To consume all final goods and services
Ô Their income consists of wages, rent, interest and profits
rusiness firms:
Ô To hire factors of production from households
Ô Produce and sell goods and services goods to the
households
Ô No corporate saving
Úactor Markets:
Úlow of factors like land, labor, capital and organization is
observed from households to firms and in return they
receive factor income like rent, wages, interest and profits
from firms.
Product Markets:
These transactions show money flow from households to
firm. xouseholds purchase consumer goods and services
from firms and in exchange they make payments to firms.
Two Sector Model
ÚACTOR PAYMENTS = xOUSExOLD INCOMES and
xOUSExOLD EXPENDITURE= TOTAL RECEIPTS OÚ TxE ÚIRM
So xOUSExOLD INCOMES = ÚACTOR PAYMENTS =
MONEY VALUE OÚ OUTPUT
Ú
Introduction
Ô This circular flow of model shows the four macroeconomic
sectors of the economy i.e.
household, business firm, government, and foreign.
Ô These four sectors capture four fundamental
macroeconomic functions and their expenditures are
combined together to purchase the economy's total
production.
Assumptions:
Ô To introduce the financial market first and assumes
household saves in the financial market.
Ô There are no inter-households borrowing.
Ô If the households save a part of their income in the
financial market (such as banks, insurance companies,
stock market etc), this reduces the expenditure of
xousehold on goods and services
Ô Ultimately reduces the flow of money/income of the
economy. So saving known as the of the
economy
Ô Again the business firms borrow from the financial markets
for investment in the capital goods (such as machineries,
factories, tools, instruments etc)
Ô This ultimately increases the productive capacity of the
business firm. So investments are known as the for
the economy
Ô Through this investment expenditure the saving of the
households deposited in the financial market are again
bought into the expenditure stream and circular flow of
economic activity continued
Government Sector: