Circular Flow of Income and Product

CHAPTER II

Circular Flow of Income and Product

(2nd Week)

A closed household economy is a society's economic system in which goods are not traded. Instead, those goods are produced and consumed by the same households.

In a barter economy, goods are bartered (traded against each other) without any medium of exchange such as money.

The closed household economy and the barter economy are together referred to as non-monetary economies.

However, goods and services are traded for money (medium of exchange) in monetary economies (modern economies).

In monetary economies, there are four economic units (Unit=agent=entity).

1) Household                2) Firm        3) Government        4) Overseas (the rest of the world)

2.1. Economic Units in a Monetary Economy

           1) Household (HH) is the basic residential unit in a monetary economy. In this unit, social and economic decisions such as consumption, inheritance, child rearing, and shelter are organized and carried out. In economics, a household is a person or a group of people living in the same residence.

2) Firm/Business is the organization that employs factors of production and produces goods and services.

3) Government is the organization that makes consumption/production decisions, collects taxes and gives governmental services. Village headmen, municipalities, ministries, the military, police departments, state hospitals, state schools are all governmental agencies.

4) Overseas (Rest of the World) are the households, firms, governmental agencies abroad. 

The economic interactions between the above mentioned economic units are carried out in the markets. The factors of production are bought and sold in factor markets. The goods and services are bought and sold in product/commodity/goods and services markets.

2.2. Economic Interactions between Economic Units in a Monetary Economy:

Circular Flow of Income and Product

In analyzing the circular flow of income and product in monetary economies, there are three scenarios:

1) Two-Sector Economy: A simple and closed economy with no government and external transactions (Overseas-rest of the world)

2) Three-Sector Economy: A mixed and open economy with government but without external transactions (Overseas-rest of the world)

           3) Four-Sector Economy: A mixed and open economy with external trade. (Overseas-rest of the world)

2.2.1. Circular Flow of Product and Income in a Two-Sector Monetary Economy

According to circular flow of income in a two-sector monetary economy, it is assumed that there are only two sectors in the economy: household sector and business (firm) sector. It is also assumed that the households do not save and consume all income.

Government does not exist. Therefore, there is no public expenditure (G), no taxes (T), no subsidies, no social security contribution, no transfer payment etc.

Overseas (rest of the world) does not exist. That is to say; the economy is closed. It has no international trade relations with the economic units abroad. That is, it does not export (X) or import (M).

(i) Household Sector: The household sector is the sole buyer of goods and services, and the sole supplier of factors of production (= means of production = resources), i.e., land, labour, capital, entrepreneurship. The household sector receives income from business sector by providing these factors of production owned by it. It spends its entire income on the purchase of goods and services produced by the business sector. The payment made by the households to the firms is “consumer expenditure (C)”. Since the household sector spends the whole income on the purchase of goods and services; then there is no saving by the households and thus no investment by the firms.