Page 34 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 2: National Income

Basic Assumptions of a Simple Circular Flow of Income Model Notes
The economy consists of two sectors: households and firms.
Households spend all of their income (Y) on goods and services or consumption (C). There
is no saving (S).
All output (O) produced by firms is purchased by households through their expenditure
(E).
There is no financial sector.
There is no government sector.
There is no overseas sector.
In the simple 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 all household income (Y) is spent (E) on the output (O) of firms, which is equal
in value to the payments for productive resources purchased by firms from households.

Example: This can be shown in an example where John earns 100.00, he doesn't save it
and spends it all on the goods and services (O) provided by the firms.

2 Sector Model with Financial Market

Financial institutions act as intermediaries between savers and investors. All the lending and
borrowings are carried on in the financial or capital market. All that is earned by the households
is not spent on consumption; a part of it is saved. This saving is deposited in the financial market
leading to a money flow from the household to the financial market. On the other hand, the firm
saves to meet its depreciation expenses and expansion. The savings of the firm going into the
financial market and borrowings made by the firm from the financial market also create money
flows.
Figure 2.2: Circular Flow of Income in 2 Sector Model with Financial System

Therefore, we can say that the savings by households and firms are leakages and borrowings by
the firms act as injections into the circular flow of income.

2.5.2 Circular Flow of Income in a 3 Sector Model

In this model, we introduce the government sector as well that purchases goods from firms and
factors services from households. Between households and the government money flows from
government to the household when the government makes transfer payments. Like old age
pension, scholarship and factors payments o the households. Money flows back to the government
when it collects direct taxes from the households.
Similarly, there are flows of money between the government sector and firm sector. Money
flows from firms to government when the government realises corporate taxes from the firms.

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