The Circular Flow of Money (With Diagram)

In this article we will discuss about the circular flow of money in an economy.

Contents:

1. Circular Flow of Money between Household and Business Sectors
2. Circular Flow of Money with Saving and Investment
3. Circular Flow of Money with Government Sector
4. Circular Flow of Money with the Foreign Sector

1. Circular Flow of Money between Household and Business Sectors:

We begin with a simple hypothetical economy where there are only two sectors, the household and business. The household sector owns all the factors of production that is land, labor, capital and enterprise. This sector receives income in the form of rent, wages, interest and profit, by selling the services of these factors to the business sector. The business sector consists of producers who produce commodities and sell them to the household sector. The household sector consists of consumers who buy commodities produced by the business sector.

Thus in the first instance, money flows in the form of such income payments as rent, wages, interest and profits from the business sector to the household sector when the former buys the services of the factors of production to produce good.

Money so received is, in turn, spent by the household sector to by goods produced by the business sector. In this way, money flows in a circular manner from the business sector to the household sector and from the household sector to the business sector in the economy.

The circular flow in a two-sector economy is depicted in Figure 1 where the flow of money as income payments from the business sector to the household sector is shown in the form of an arrow in the lower portion of the diagram. On the other hand, the flow of money as consumption expenditure on the purchase of goods and services by the household sector is shown to go to the business sector by an arrow in the upper portion of the diagram.

As long as income payments by the business sector for factor services are returned by the household sector to purchase goods, the circular flow of income payments and consumption expenditure tends to continue indefinitely. Production equals sales or supply equals demand, and the economy will continue to operate at this level in a circular flow of money.

Assumptions:

The above analysis of the circular flow of money is based on a number of assumptions:

1. It is assumed that the household sector spends the entire income received from the business sector on buying goods and services produced by the latter.

2. The business firms keep their production exactly equal to their sales, and there are no changes in their inventories.

3. The business sector does not keep any undistributed money as reserve. The money it receives by selling goods and services to the household sector is fully spent in making payments as rent, wages, interest and profits to the household sector.

It is these assumptions that keep the flow of money to move in a circular manner in the economy. But these assumptions are unrealistic and do not fit in the actual working of the economy. The fact is that there are regular withdrawals and injections from the circular flow of money in the economy.

A withdrawal or leakage is any income that does not enter into the circular flow of money, and an injection is an addition to the circular flow of money. A leakage occurs in the income flow and an injection in the expenditure flow.

2. Circular Flow of Money with Saving and Investment:

In the circular flow of money, saving is one of the leakages and investment is an injection. In fact, the household and business sectors do not spend their entire money income. The consumers who represent the household sector do not spend their income wholly in purchasing goods and services.

Rather, they save a part of their income for a variety of motives. Similarly, business firms do not spend their entire income from the sale of goods. But they keep a part of it in the form of undistributed profit. Such savings of consumers and firms are not hoarded but are invested in bonds, shares, debentures, etc. in the capital market. They flow in to the capital market.

On the other hand, business firms borrow funds from the capital market for making investment. Thus savings which flow into the capital market are taken away by the business sector for investment and the circular flow of money is maintained in the economy.

Figure 2 shows how the circular flow of money is altered by the inclusion of saving and investment.

Expenditure has now two paths:

(i) Directly via consumption from the households to the business sector, and

(ii) Indirectly via investment expenditure by the business sector.

In the centre of Figure 2, there is the capital (or credit or financial) market which shows the inflow of savings from the household sector and the business sector into the capital market, and the outflow of investment into the business sector from the capital market. The capital market coordinates the saving and investment activities of the household and business sector s and maintains the circular flow of money in the economy.

3. Circular Flow of Money with Government Sector:

So far we have been working on the circular flow of a two-sector model of an economy. To this we add the government sector so as to make it a three-sector closed model. For this, we add taxation and government purchases (or expenditure) in our presentation. Taxation is a leakage from the circular flow and government purchases are injections into the circular flow of money.

First, take the circular flow between the household sector and the government sector. Taxes in the form of personal income tax and commodity taxes paid by the household sector are outflows or leakages from the circular flow. But the government purchases the services of the households, makes transfer payments in the form of old age pensions, unemployment relief, sickness benefit, etc., and also spends on them to provide certain social services like education, health, housing, water, parks and other facilities. All such expenditures by the government are injections into the circular flow of money.

Next take the circular flow between the business sector and the government sector. All types of taxes paid by the business sector to the government are leakages from the circular flow. On the other hand, the government purchases all its requirements of goods of all types from the business sector, gives subsidies and makes transfer payments to firms in order to encourage their production. These government expenditures are injections into the circular flow of money.

Now we take the household, business and government sectors together to show their inflows and outflows in the circular flow. As already noted, taxation is a leakage from the circular flow. It tends to reduce consumption and saving of the household sector. Reduced consumption, in turn, reduces the sales and incomes of the firms. On the other hand, taxes on business firms tend to reduce their investment and production.

The government offsets these leakages by making purchases from the business sector and buying services of the household sector equal to the amount of taxes. Thus total sales again equal production of firms. In this way, the circular flows of income and expenditure remain in equilibrium.

Figure 3 shows that taxes flow out of the household and business sectors and go to the government. Now the government makes investment and for this purchases goods from the household. Thus government purchases of goods and services are an injection in the circular flow of income and taxes are leakages.

If government purchases exceed 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 household sector in the form of saving.

On the other hand, if net taxes exceed government purchases the government will have a budget surplus. In this case, the government reduces the public debt and supplies funds to the capital market which are received by the business sector.

4. Circular Flow of Money with the Foreign Sector:

So far the circular flow of income and expenditure 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. Exports are an injection or inflows into the economy. They create incomes for the domestic firms. When foreigners buy goods and services produced by domestic firms, they are exports in the circular flow of income. On the other hand, imports are leakages from the circular flow.

They are expenditures incurred by the household sector to purchase goods from foreign countries. Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. The household sector buys goods imported from abroad and makes payment for them of money. The householder may receive transfer payments from the foreign sector for the services rendered by them in foreign countries.

On the other hand, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow. Similarly, there are many services rendered by business firms to foreign countries such as shipping, insurance, banking, etc. for which they receive payments from abroad.

They also receive royalties, interests, dividends, profits, etc. for investments made in foreign countries. On the other hand, the business sector makes payments to the foreign sector for imports of capital goods, machinery, raw materials, consumer goods, and services from abroad. These are the leakages from the circular flow.

Like the business sector, modern governments also export and import goods and services, and lend to and borrow from foreign countries. For all exports of goods, the government receives payments from abroad. Similarly, the government receives payments from foreigners when they visit the country as tourists and for receiving education, etc. and also when the government provides shipping, insurance and banking services to foreigners through the state-owned agencies.

It also receives royalties, interest, dividends etc. for investments made abroad. These are injections into the circular flow. On other hand, the leakages are payments made for the purchase of goods and services to foreigners.

Figure 4 shows the circular flow of the four-sector open economy with saving, taxes and imports shown as leakages from the circular flow on the right hand side of the figure, and investment, government purchases and exports as injections into the circular flow on the left side of the figure. Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors—the household, the business and the government. These outflows and inflows pass through the foreign sector which is also called the “Balance of Payments Sector.”

Thus Figure 4 shows the circular flow of money where there are inflows and outflows of money, receipts and payments among the business sector, the household sector, the government sector and the foreign sector in currents and cross-currents.