Circular Flow of Income:
The modern economy is a monetary economy. In the modern economy, money is used in the process of exchange. Money has facilitated the process of exchange. Money has facilitated the process of exchange and has removed the difficulties of the barter system. Thus money acts as a medium of exchange. The households supply the economic resources or factors to the productive firms and receive in return the payments in terms of money corresponding to the flows of economic resources and the flows of goods and services. But each money flow is in the opposite direction to the real flow.
Circular Income Flow in a Three-Sector Economy:
The circular flow of a two-sector model of an economy consists of the household and the business sector. We add the government sector to make it a three-sector closed model of the circular flow of income and expenditure. For this, we add taxation and government purchases (or expenditure) in our presentation. Taxation is a leakage from the circular flow.
First, take the circular flow between the household sector and the government sector. Taxes in personal income tax and commodity taxes paid by the household sector are outflows or leakages from the circular flow. But the government purchases the services of the households, makes transfer payments in the form of old-age pensions, employment relief, sickness benefits, etc., and also spends on them to provide certain social services like education, health, housing, water, parks and other facilities. All such expenditures by the government are injections into the circular flow.
Next is the circular flow between the business sector and the government sector. All types of taxes paid by the business sector to the government are leakages from the circular flow. On the other hand, the government purchases all its goods requirements of all types from the business sector gives subsidies and makes transfer payments to firms to encourage their production. These government expenditures are injections into the circular flow.
We take the household, business and government sectors together to show their inflows and outflows in the circular flow. As already noted, taxation is a leakage from the circular flow. It tends to reduce consumption and saving of the household sector. Reduced consumption, in turn, reduces the sales and incomes of the firms. On the other hand, taxes on business firms tend to reduce their investment and production. The government offsets these leakages by making purchases from the business sector and buying senses of the household sector equal to the amount of taxes. Thus total sales again equal the production of firms. In this way, the circular flow of income and taxes are leakages.
It can be seen that taxes flow out of the household and business sectors and go to the government. Now, the government makes investments and purchases goods from firms and factors of production from households. Thus government purchases of goods and services are an injection in the circular flow of income, and taxes are leakages.
If government purchases exceed net taxes, the government will incur a deficit equal to the differences between the two, i.e., government expenditure and taxes. The government finances its deficit by borrowing from the capital market, which receives funds from households in the form of savings. On the other hand, if net taxes exceed government purchases, the government will have a budget surplus. In this case, the government reduces the public debt and supplies funds to the capital market, which firms receive.
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