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Subject ECONOMICS
Paper No and Title 4, Basic Macroeconomics
Module No and Title 2, Circular Flow of Income and Expenditure
Module Tag ECO_P4_M2
ECONOMICS PAPER No. : 4 – Basic Macroeconomics
MODULE No. : 2- Circular Flow of Income and Expenditure
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. The Four Macroeconomic Sectors
3.1 The Household Sector
3.2 The Firms Sector
3.3 The Government Sector
3.4 The Foreign Sector
4. The Three Markets
4.1 The Goods Market
4.2 The Factor Market
4.3 The Financial Market
5. The Circular Flow of Income in a Two-Sector Model
5.1 Two-Sector Model with Saving and Investment
6. The Circular Flow of Income in a Three-Sector Model
7. The Circular Flow of Income in a Four-Sector Model
8. Leakages and Injections in the Circular Flow of Income
9. Summary
ECONOMICS PAPER No. : 4 – Basic Macroeconomics
MODULE No. : 2- Circular Flow of Income and Expenditure
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1. Learning Outcomes
After studying this module, you shall be able to
Know the four macroeconomic sectors and the three markets.
Learn the interdependence among the sectors and the markets.
Identify the different models of the circular flow of income.
Evaluate the leakages and injections in the circular flow.
Analyse the significance of circular flow of income in macroeconomics.
2. Introduction
Macroeconomics is the branch of economics that studies the economic behaviour of all the agents
in the economy; i.e. it is the study of the economy as a whole. In other words, macroeconomics is
the study of aggregate outcomes of the decisions taken by the different agents in an economy.
To begin the study of basic macroeconomics let us introduce the concept of the circular flow of
Income. The circular flow of income forms the basis for all the macroeconomic models of the
economy and it is imperative to understand the circular flow model for understanding essential
concepts like national income, aggregate demand and aggregate supply.
The circular flow of income describes the movement of goods or services and income among the
different sectors of the economy. It illustrates the interdependence of the sectors and the markets
to facilitate both real and monetary flow.
The real flow refers to the flow of factor services and flow of goods and services. The flow of
factor services from the households to the firms and the flow of goods and services from firms to
the household is the real flow. The flow of factor services generates money flows in the form of
factor payments which the firms pay the household and similarly the household need to pay the
firms for the flow of goods and services. The movement to the money/cash payment from one
sector to the other sector corresponding to the real flow is referred to as the monetary flow. Thus,
the income of one sector becomes the expenditure of the other and the supply of goods and
services by one sector becomes the demand of the other sector. The real flow and monetary flow
move in a circular manner in an opposite direction. A continuous flow of production, income and
expenditure is known as the circular flow of income.
ECONOMICS PAPER No. : 4 – Basic Macroeconomics
MODULE No. : 2- Circular Flow of Income and Expenditure
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3. The Four Macroeconomic Sectors
3.1 The Household Sector
This sector includes all the individuals in the economy. The primary function of this sector is to
provide the factors of production. The factors of production include land, labour, capital and
enterprise. The household sectors are the consumers who consume the goods and services
produced by the firms and in return make payments for the same.
3.2 The Firms Sector
This sector includes all the business entities, corporations and partnerships. The primary function
of this sector is to produce goods and services for sale in the market and make factor payments to
the household sector.
3.3 The Government Sector
This sector includes the center, state, and local governments. The prime function of this sector is
to regulate the functioning of the economy. The government sector incurs both revenue as well as
expenditure. The government earns revenue from tax and non-tax sources and incurs expenditure
for provide essential public services to the people.
3.4 The Foreign Sector
This sector includes transactions with the rest of the world. Foreign trade implies net exports
(exports minus imports). Exports include goods and services produced domestically and sold to
the rest of the world and imports include goods and services produced abroad and sold
domestically.
4. The Three Markets
4.1 The Goods Market
In this market the goods and services are exchanged among the four macroeconomic sectors. The
consumers are the household, government and the foreign sector while the producers are the
firms.
4.2 The Factor Market
The factors of production are traded through this market. For the production of final goods and
services, the firms obtain the factor services and make payments in the form of rent, wages and
profits for the services to the household sector.
ECONOMICS PAPER No. : 4 – Basic Macroeconomics
MODULE No. : 2- Circular Flow of Income and Expenditure
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