CIRCULAR FLOWS OF INCOME AND EXPENDITURE IN A TWO SECTOR
MODEL
Q.2 Explain circular flows of income and expenditure in a two-sector model.
Ans:
The two-sector model includes only household sector and business sector (firms). It is a private
closed economy. There is no government and no foreign trade. It is a simple and hypothetical model.
A two sector model is obviously an unrealistic model. However, it is a
convenient starting point to analyze the circular flows.
The basic features and functions of the households and firms are as under :
Households :
a) The households are the owners of all factors of production.
b) Their total income consists of rent, wages, interest and profit.
c) They are consumers of all the consumer’s goods and services.
d) They save a part of their income and supply finance to the firms through capital market.
The Business Firms :
a) Firms own no resources of their own.
b) They hire and use the factors of production owned by household.
c) They produce and sell goods and services to the households.
d) They do not save (i.e. there is no corporate saving).
The circular flows of income and expenditure in a Two-Sector Economy is explained in following
figure :
The upper half of figure is related to Factor Market. In factor market,
-- Households provide factors of production (FOP) like land, labour, capital and
entrepreneurship to the firms. This is Real Flow.
-- Households get factor incomes like rent, wages, interest and profit from the firms (as
firms make factor payments to the households). This is Money Flow.
Factor services (real flow) and factor payments (money flow) are in opposite directions.
The lower half of figure is related to Commodity Market. In commodity market,
-- Firms sell goods and services to the households. This is Real Flow.
-- Firms get payment for goods and services from households (as households make
consumption expenditure on goods and services produced by firms). This is Money Flow.
Again we find that real flow and money flow are in opposite directions.
Important Identities :
The values of flows are equal.
For example ….
(a) Factor incomes are equal to factor payments i.e. Y FP w + r + i + p
(b) Household expenditure are equal to value of output i.e. w + r + i + p
Thus, Y FP Where,
FP w + r + i + p Y = household income, w + r + i + p V FP = factor payments,
V Y w = wages, r = rent, i = interest, p = profit
V = value of output
In short,
Household Income Factor Payments The Money Value of output i.e. Y FP
The Two-Sector Model with Saving:
To explain the role of saving, we assume that all savings are made by only households. Now
financial sector is introduced in two-sector
model. Here, financial sector includes only
banks and financial intermediaries (FIs) like
insurance companies, industrial finance
corporations and so on. They accept
deposits from the households and invest it
in the business sector in the form of
loans and advances. Now two-sector model
with financial sector is shown in following
figure :
Now, income of households (Y) is divided
into two parts :
(i) Consumption expenditure
(C) and (ii) Savings (S).
Both reach to the
firms. C reaches directly and S reaches
indirectly.
Circular Flows in Two – Sector Model with the Financial Sector
Equilibrium Condition :
The total expenditure (E) is sum total of consumption expenditure (C) and investment
expenditure (I).
Symbolically, E = C + I ……(i)
The total income received (Y) is allocated between consumption (C) and saving (S).
Symbolically, Y = C + S …. (ii)
Total expenditure is equal to total income i.e. E = Y or C + I = C + S ….(iii)
By cancelling C, we have I = S …. (iv)
It means injection (I) is equal to withdrawal (S)
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