Business or firms take economic resources from households and in turn provide them with goods and services. He sells his services to Sandra. He needs a place to stay and he needs food to eat. The business sector consists of producers who produce commodities and sell them to the household sector. Leakages reduce the flow of income. In factor markets, households and firms play different roles than they do in the markets for goods and services.
The Firm Sector The flows in and out of the firm sector of an economy must balance. However, the factors of production, such as labor, land, and capital flow from the households to the firms to be converted into goods and the services that will be consumed by the households. What is important is that total expenditure must equal total output—which is equivalent to saying that total leakages must equal total injections. What are his total expenditures? This process repeats itself and forms the circular flow of income. Rather, they save a part of their income for a variety of motives. In order to obtain a clear idea of the relations between the numerous economic units in a country, it is best to reduce them to homogeneous groups. A residual of each market comes in capital market as saving which in turn is invested in firms and government sector.
Households The primary economic function of households is to supply domestic firms with needed factors of production - land, human capital, real capital and enterprise. An injection of new spending will increase the flow. To stop it, the government adopts such measures as to increase exports and decrease imports. Again, this reflects the fact that there are two sides to each transaction. They pay them to factors in the form of wages, rent, interest and profits.
Similarly, there are many services rendered by business firms to foreign countries such as shipping, insurance, banking, etc. The money of the businesses, through salaries paid and goods produced, becomes the income of the individuals. Imports are equivalent to borrowing from the rest of the world. If households fear the onset of a recession, then they start to save money, which is considered a leakage in the system. Not all households own firms in this way, but in macroeconomics it is sufficient to think about the average household that does own stock in firms. This leads to a cumulative rise in employment, income, output, and prices over a period of time. Production equals sales or supply equals demand, and the economy will continue to operate at this level in a circular flow of money.
Similarly, the government receives payments from foreigners when they visit the country as tourists and for receiving education, etc. Sometimes, households will save their money, purchase foreign goods, or use their income to pay taxes. So this is expenses and here we're going to be thinking in terms of economic profit because we're really just thinking about how much money is coming out of this firm, out of this business. The household sector consists of consumers who buy commodities produced by the business sector. It summarizes the behavior of banks and other financial institutions.
Households spend all their income, and this money becomes the revenue of firms. In the model taxes and savings leakages have reduced consumption to Rs. Still, the circular flow still teaches us something very important. Circular Flow in a Two Sector Economy: We begin with a simple hypothetical economy where there are only two sectors, the household and business. Figure 2 shows that the equality between saving and investment comes about through the credit or capital market. Government finances are discussed in. The government offsets these leakages by making purchases from the business sector and buying services of the household sector equal to the amount of taxes.
While basic circular flow of spending and income prevails, the real working of the economy adds complications in our simple two sector theoretical structure or model of the economy described above. Tourism can cause leakage through funds transitioning between those who live in a particular area and chosen tourist destinations. Assumptions: The above analysis of the circular flow of money is based on a number of assumptions: 1. Thus the circular flow of income and expenditure tells us about the importance of compensatory fiscal policy. If you like, imagine that different firms specialize in different kinds of pizza. We see in the model that government expenditure is not equal to taxes and savings are no longer equal to intended investments but the macroeconomic equilibrium or the circular flow of the economy obtains nevertheless because total expenditure is equal to the value of total output. Conclusions of Circular Flow in a Simple Economy: 1.
Meaning of Circular Flow of Economic Activity: It means continual circular movement of money and goods in the economy. Circular Flow of Money between Household and Business Sectors : We begin with a simple hypothetical economy where there are only two sectors, the household and business. We're assuming that there's no taxes over here. There are only 2 sectors in the economy Households and Firms. As this is true for each individual firm, it is also true for the sector as a whole. Therefore, as well as save, households are also likely to pay taxes T to the government G , and further income is withdrawn out of the circular flow of income.