The circular flow of income and expenditure refers to the process whereby the national income and expenditure of an economy flow in a circular manner continuously through time. The various components of national income and expenditure such as saving, investment, taxation, Govt, expenditure, exports, imports, etc. flow in the form of currents and cross currents in such a way that national income equal national expenditure. The circular flow of economic activity is maintained not only in two sector closed economy but also in three sector economies and four sectors, open economy in which foreign trade is included. In order to attain the circular flow of economic activity necessary adjustments of transactions in the various sectors of the economy are made.
The circular flow in a three sector closed economy:
The three sector model of an economy includes government transactions side by side house hold and business sectors. These three sectors the economy is formed as "closed economy" as foreign transactions are excluded from it. Thus in a closed economy only three sectors such as households, firms. To arrive at the national income in a closed economy we combine the income and product of the household sector and business sector with the income and product of the Govt, sector.
The household sector owns the factors of production viz land, labour and capital. Household sector receives income by selling the services of factors to the business (firms) sectors. Households are basically consumer units and their climate aim is to satisfy the wants.
Business sector (firms), on the other hand, employs the factors of production or resources (inputs) and produces the final output for sale. Business firms take economic resources from households
and intern supply them goods and services. These basic exchanges are known as real flows. Business sector given money for the purchase of scarce economic resources from the resource market and also receives money by selling goods and services in the product market. Thus business sector pays for factor services and incur factor costs and receives income in return.
Government incurs expenditure on goods and services and gets receipts in the firm of taxes. Taxes constitute an important leakage besides saving. Govt, expenditure on the purchase of goods and services constitutes an important source of injection. When Govt, takes money in form of taxes, the ability to spend of the taxpayer is reduced but this is offset through spending more on the purchase of goods and services called injection. This act of levying taxes (leakage) and incurring public expenditure is called fiscal action. The working of the three sector closed economy involving Govt, transactions is shown in the diagram given below.
First of all let us take the circular flow between the household sector and Govt sector. Taxes that includes both direct tax and commodity tax paid by the household sector constitute leakage firm circular flow. But Govt purchases the services of the household, makes transfer payments in the fort of old age pensions, unemployed, relief etc and spends on the social services like education, health, etc. All such expenditures by the Govt are injections into the circular flow.
(ii) The circular flow between the business sector and the Govt sector. All types of taxes paid by the business sector also constitute leakage from the circular flow. On the other hand Govt purchases final goods from the business sector, provides subsidies and makes transfer payments to firms in order to help them in production. These government expenditures are injections into the circular flow.
(iii) The inflow and outflow among household, business and government sectors:-
Taxation constitutes leakages from the circular flow; it reduces savings and- consumption of the households. The reduction in consumption leads to decrease in the sales and incomes of the firms. Taxes on business firms will also curtain investment. The Govt offsets these leakages by making purchases from business sector and household sectors, thus total sales again equal production of firms. In this way the circular lows of income and expenditure remain in equilibrium.
In the above diagram taxes are shown to flow out of the house hold and business sectors and go to the government. Govt makes investment and purchases goods from firms and also factors from households. This Govt purchases firms an injection in the circular flow of income and taxes are leakages.
If Govt purchases exceed net taxes then the Govt will incur a deficit the difference between taxes precede and public expenditure). The Govt finances its deficit by borrowing from the capital market which receives funds from households in the form of saving. On the other hand, if net taxes exceed Govt purchases the Govt will have a budget surplus. In such a case the Govt reduces the public debt and supplies fund to the capital market which are received by firms.