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 different sectors. 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.

Two Sector Model:

It signifies 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.

                                   

The circular flow diagram divides the economy into two sectors: one concerned with producing goods and services, and the other with consuming them. Resources are converted into goods and services by business, and in this transformed state travel back to consumers. Money flows in the opposite direction. These flows involve two markets in which exchange takes place: the resource or factor market in which business buys resources, and the goods and services market in which business sells goods. (Some economists define a "factor of production" as the service of some resource. If resources are land, labor, and capital, the factors of production are the services of land, labor, and capital. We will ignore the distinction between resources and factors of production in the discussion that follows.)

Three Sector Model

It includes household sector, producing sector and government sector. It will study a circular flow income in these sectors excluding rest of the world i.e. closed economy income. Here flows from household sector and producing sector to government sector are in the form of taxes. The income received from the government sector flows to producing and household sector in the form of payments for government purchases of goods and services as  well as payment of subsides and transfer payments. Every payment has a receipt in response of it by which aggregate expenditure of an economy becomes identical to aggregate income and makes this circular flow and unending.

Four Sector Model

A modern monetary economy comprises a network of four sector economy these are- 1.Household sector 2.Firms or Producing sector 3.Government sector 4.Rest of the world sector. Each of the above sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. Money facilitates such an exchange smoothly. A residual of each market comes in capital market as saving which in turn is invested in firms and government sector. Technically speaking, so long as lending is equal to the borrowing i.e. leakage is equal to injections, the circular flow will continue indefinitely. However this job is done by financial institutions in the economy.

                         

Leakages: These are those flow variables which have a negative impact on the process of production in the economy. These variables reduce the flow of income in the economy; hence called withdrawals or leakages. These are:

  1. Savings
  2. Imports
  3. Taxes

Injections: These are those flow variables that cause an expansion in the process of production in the economy. These are:

  1. Investment
  2. Exports
  3. Government expenditure

Basically all these are expenditure variables-expenditure on the goods and services produced in the economy. These variables affect the economy in two ways:

  • Add to production capacity of the economy
  • Generate demand for the produced goods and services.

Relationship between Leakages and Injections in Circular Flow

The circular flow will remain at a constant level if saving(S), Tax revenue (T), and imports (M), which are leakages, are equal to investment (I), Government expenditure (G), and exports (X) which are injections in the circular flow of income.                         

       S+T+M=I+G+X

  • If all leakages are equal to injections, the economy will not change.
  • If leakages are greater than injections, than the income level will decline and the economy will contract/fall into a recession.
  • If injections are greater than he leakages, than the income level eill rise and the economy will expand into a recovery.