Firms use these factors to produce goods and services which they sell to the households. As such, the circular flow is of immense significance for studying the functioning of the economy and for helping the government in formulating policy measures. The Foreign Sector The foreign sector is perhaps the hardest part of the circular flow to understand because we have to know how international transactions are carried out. 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. In a simple economy which has neither government, nor foreign trade, the value of output produced which we denote by Y is equal to the value of output sold.
Note that money, by definition, flows from buyer to seller in all markets. The circular flow of income describes these flows of dollars. In the household sector, total spending by the household equals total income for the household. Business firms consider the interest rate as cost of borrowing and the rise in the interest rate as a result of borrowing by the Government lowers private investment. In goods and services markets, households buy finished products from firms that are looking to what they make. It sells him goods and services.
On the other hand, investment means some money is spent on buying new capital goods to expand production capacity. Also, sometimes extra money is added to the diagram. Consequently, smaller amount of goods will be produced and therefore fewer capital goods like machinery will be indeed with the result that fixed investment will tend to fall. A residual of each market comes in capital market as saving which in turn is invested in firms and government sector. Some examples of factors of production are labor the work was done by people , capital the machines used to makes products , land, and so on.
Let me make it clear that this is building rent or building lease. It will be seen that government purchases of goods and services from firms and households are shown as flow of money spending on goods and services. Of course, international transactions in practice are more complicated than these simple examples. Government borrowing increases the demand for credit which causes rate of interest to rise. Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors—the household, the business and the government. Then flow of investment expenditure is shown as borrowing by business firms from the financial market.
Hence, in the Basic Circular Flow of Income Model the flows of money and goods and services always correspond in value but move in opposite directions. However, in national income accounts we are concerned with actual saving and actual investment. Taxes in the form of personal income tax and commodity taxes paid by the household sector are outflows or leakages from the circular flow. Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. The idea is the same either way.
We need frameworks to help us make sense of the data that we gather. Circular money flow with saving and investment is illustrated in Fig. Here, the source of income for the government is in the form of taxes, subsidies and transfer payments made by the households and business firms. As we have already seen, a free market economy consists of two components, or sectors, as they are called. Now, what will happen if planned investment expenditure falls short of the planned savings? Thus we see that money flows from business firms to households as factor payments and then it flows from households to firms. So you can view it as at the end of the day, the households are really giving the firms the factors of production. For this, we add taxation and government purchases or expenditure in our presentation.
The money flow from households and business firms to the government is labelled as tax payments in Fig. Businesses provide individuals with income in the form of compensation in exchange for their labor. Both of these situations will result in leakages from the circular flow. This ownership is achieved through many forms, ranging from firms that are owned and operated by individuals to giant corporations whose ownership is determined by stock holdings. You would be triple counting.
Quesnay visualised the steps in the process in the Tableau économique. In free market economies there exists a set of institutions such as banks, insurance companies, financial houses, stock markets where households deposit their savings. A result, circular flow of money speeding and income remains undiminished. Finally, the households use their income to buy goods and services, thereby transferring all their income back to the firms. The Simplest Version of the Circular Flow We can make this idea more precise, using the pizza economy to illustrate. This will lead to the fall in total incomes of the households.
Circular flow of income The circular flow of income is a way of representing the flows of money between the two main groups in society - producers firms and consumers households. Although this version of the circular flow is simple, it teaches us four key insights that remain true albeit in slightly refined forms in more sophisticated versions as well. It taxes us, T, and uses this money to finance its spending. They create incomes for the domestic firms. We will now explain if households save a part of their income, how their savings will affect money flows in the economy.