Circular Flow of Income Q7

Thomas Sim PEA2066

Q.
a) With an aid of a diagram, explain circular flow of income in a two-sector economy. (10 marks)

b) Differentiate the functions of commercial bank and central bank. (10 marks)

(20 marks, 2011 Q7)

A.
Circular flow of income diagram of a two-sector economy.

Be reminded that Circular Flow of Income can be drawn for three-sector economy with the inclusion of government, and four-sector with the inclusion of foreign trade.

 

In economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers.[1][2] 

In the two-sector economy circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income.[1] Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households. 

More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports. These are illustrated in the three-sector or four-sector economy circular flow diagrams above.

Human wants are unlimited and are of recurring nature therefore, production process remains a continuous and demanding process. In this process, household sector provides various factors of production such as land, labor, capital and enterprise to producers who produce by goods and services by coordinating them. Producers or business sector in return makes payments in the form of rent, wages, interest and profits to the household sector. Again household sector spends this income to fulfill its wants in the form of consumption expenditure. Business sector supplies them goods and services produced and gets income in return of it. Thus expenditure of one sector becomes the income of the other and supply of goods and services by one section of the community becomes demand for the other. This process is unending and forms the circular flow of income, expenditure and production.[3]

A continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning nor an end. The circular flow of income involves two basic assumptions:- 1.In any exchange process, the seller or producer receives the same amount what buyer or consumer spends. 2.Goods and services flow in one direction and money payment to get these flow in return direction, causes a circular flow.
Circular flows are classified as: Real Flow and Money Flow. Real Flow- In a simple ♙, the flow of factor services from households to firms and corresponding flow of goods and services from firms to households is known to be as real flow.
Assume a simple two sector economy- household and firm sectors, in which the households provides factor services to firms, which in return provides goods and services to them as a reward. Since there will be an exchange of goods and services between the two sectors in physical form without involving money, therefore, it is known as real flow.
Money Flow- In a modern two sector economy, money acts as a medium of exchange between goods and factor services. Money flow of income refers to a monetary payment from firms to households for their factor services and in return monetary payments from households to firms against their goods and services. Household sector gets monetary reward for their services in the form of rent, wages, interest, and profit form firm sector and spends it for obtaining various types of goods to satisfy their wants. Money acts as a helping agent in such an exchange.
In the two sector circular flow of income model, the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is:
Y = E = O
This means that the expenditure of buyers (households) becomes income for sellers (firms). The firms then spend this income on factors of production such as labour, capital and raw materials, "transferring" their income to the factor owners. The factor owners spend this income on goods which leads to a circular flow of income.

Assumptions[edit]

The basic circular flow of income model consists of seven assumptions:
  1. The economy consists of two sectors: households and firms.
  2. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).
  3. All output (O) produced by firms is purchased by households through their expenditure (E).
  4. There is no financial sector.
  5. There is no government sector.
  6. There is no foreign sector.
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