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Karnataka Class 12 Commerce Economics Circular Flow Of Income Notes

Karnataka Class 12 Commerce Economics Circular Flow Of Income Notes

Karnataka Class 12 Commerce Economics Circular Flow Of Income : The Karnataka State Open University established on 1st June 1996 vide Karnataka Govt. Notification No. ED 1 UOV 95 dated 12th February 1996 – KSOU Act 1992 is considered to be a reputed Open University amongst the open learning institutions in the country. Keeping in view the educational needs of our country, in general, and state in particular the policies and programmes have been geared to cater to the needy.

For more than 18 years, KSOU has redefined the way students are educated, with the aim of imparting knowledge by professionally managed, multi- disciplinary and multi- faceted oasis

Karnataka Class 12 Commerce Economics Circular Flow Of Income Notes

Karnataka Class 12 Commerce Economics Circular Flow Of Income : The circular flow of income is a way of representing the flows of money between the two main groups in society – producers (firms) and consumers (households). These flows are part of the fundamental process of satisfying human wants.

As we have already seen, a free market economy consists of two components, or sectors, as they are called. These are firms and households. People in households work for firms (selling their factor services) and receive wages in exchange. On the scale of the whole economy, this is known as national income – the total amount of income earned over a given time period. This money is spent on food, clothing, transport, entertainment etc, and so it returns to the firms. This is the circular flow.

Download here PDF Format Karnataka Class 12 Commerce Economics Circular Flow Of Income Complete Notes 

Karnataka Class 12 Commerce Economics Circular Flow Of Income Notes

Karnataka Class 12 Commerce Economics Circular Flow Of Income : National income, output, and expenditure are generated by the activities of the two most vital parts of an economy, its households and firms, as they engage in mutually beneficial exchange.

What is the circular flow?

The circular flow of income and spending shows connections between different sectors of an economy

  • It shows flows of goods and services and factors of production between firms and households
  • The circular flow shows how national income or Gross Domestic Product is calculated

Businesses produce goods and services and in the process of doing so, incomes are generated for factors of production (land, labour, capital and enterprise) – for example wages and salaries going to people in work.

Leakages (withdrawals) from the circular flow

Not all income will flow from households to businesses directly. The circular flow shows that some part of household income will be:

  • 1.Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit
  • 2.Paid to the government in taxation (T) e.g. income tax and national insurance
  • 3.Spent on foreign-made goods and services, i.e. imports (M) which flow into the economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of production (output)

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.

  1. Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology
  2. The government, i.e. government expenditure (G) e.g. on the NHS or defence
  3. Overseas consumers buying UK goods and service, i.e. UK export expenditure (X)

An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow.

Building up the model

In this next series of images we build up the circular flow model from just having a domestic sector and then adding in an external sector (exports and imports) before including the financial sector which channels savings and hopefully provides the finance available to fund investment.

The Domestic Circular Flow of Income and Spending

The external sector involves businesses exporting goods and services overseas (X) and consumers and business buying imported products from other countries (M)

The domestic circular flow

The Circular Flow of Income and Spending with the External Sector added

Circular flow with external sector

Financial Sector Added to the Circular Flow Model

Figure 5 Circular flow – 3 sector, open economy

A reminder:

The leakages from the circular flow are:

  • Savings (S)
  • Taxation (T)
  • Purchase of imported goods and services (M) (goods and services in but money out – UK firms pay overseas ones)

The injections are

  • Investment (I) – expenditure on capital goods
  • Sale of exports (X) (goods and services out, but money now flows in)
  • Government Expenditure (G)

An economy is in equilibrium when injections match the leakages.

The standard codes used in this model, and in economics in general are:

Y = National Income
C = Domestic Consumption
S = Savings
M = Imports
T = Taxation
I = Investment
X = Exports
G = Government Spending

The circular flow model of an economy is very useful within the study of economics. We will be looking at the actions and behaviour of firms and households, and how governments interact with them. We will look at how changes in the leakages and injections affect the stability of an economy.

Karnataka Class 12 Commerce Economics Circular Flow Of Income Notes

Karnataka Class 12 Commerce Economics Circular Flow Of Income : The five-sector circular flow model describes the operation of the economy and the linkages between the main sectors in the economy. The five-sector model is based on dividing the economy into five sectors. A sector may be defined as a part of the economy where the participants are engaged in a similar type of economy activity.

1. Individuals :

  • This sector consists of all individuals in the economy.
  • These individuals are the owners of productive resources, and the consumers in our economy.
  • Individuals supply factors of production (inputs) such as labour and enterprise to businesses, which they use to produce goods and services. As a reward for supply resources such as labour and enterprise to firms, individuals receive incomes – rent, wages, interest and profit

2. Businesses :

  • This sector consists of all the business firms engaged in the production and distribution of goods and services (apart from financial services).
  • It concerns all their activities involved with buying factors of production and using them to produce and sell goods and services.
  • Individuals and businesses are interdependent.

3. Financial institutions :

  • This sector consists of all those institutions that are engaged in the borrowing and lending of money, acting as the intermediaries between those who save, and borrowers of money.
  • Financial institutions are needed for individuals and firms to be able to undertake saving and investment. They perform the function of mobilising savings for investment.
  • Savings: leakage; Investment: injection

4. Government :

  •  In Australia, this sector consists of the Commonwealth, State and local governments.
  • It is involved in the satisfaction of collection (community) wants.
  • It obtains the resources to do this through imposing taxes on the other sectors of the economy.
  • It uses this tax revenue to undertake various government expenditure

5. International Trade

Figure 1 Circular flow of income

We can see this circular flow in Figure 1. Households sell their factor services to firms (in the factor markets) and in exchange receive wages (the left hand side of the flow). In the meantime, households spend this income on goods and services (in the goods market) and in exchange receive the goods and services themselves (the right hand side of the flow). Economists call the wages plus the other forms of income, national income and give it the code ‘Y‘. Domestic consumption is given the code ‘C‘.

Not all income is spent, however. Some is saved. Savings are coded as ‘S‘. Other money is used to buy goods or services produced overseas. The money to buy these goods and services flows out of the country. It is given the code ‘M‘ for imports.

Figure 2 Circular flow – savings and imports

S and M are called leakages from the circular flow. The effect of these leakages can be seen in Figure 2.


A leakage is any income not passed on in the circular flow.

On the other hand, some firms make and sell exports overseas, and others borrow money and invest it in their firms in the form of capital goods. These are coded ‘X’ for exports and ‘I‘ for investment and are called injections as the money returns into the circular flows.


An injection is any expenditure not originating in the household sector, including investment, government spending and exports.

Figure 3 Circular flow – two sector, open economy

This is a 2-sector, open economy. The flow will be balanced and therefore in equilibrium when the injections are equal to the leakages. If the leakages are greater than the injections then national income will fall, while if injections are greater than leakages national income will rise. This starts to show us some possible policies to promote growth – policies that help boost exports or investment will lead to more injections into the circular flow and therefore boost national income.

We called the economy illustrated in Figure 3 an open economy because it is open to trade with the outside world. If it did not trade outside of itself, we would call it a 2-sector, closed economy.

Try drawing a circular flow for a 2-sector closed economy and then click on 2-CLOSED to check your answer.

In almost all economies, the government plays an active part. It taxes us, T, and uses this money to finance its spending. Even though this partly goes to pay themselves and their bureaucracy, as well as funding schools and hospitals, it finds its way back into the flow. This spending is coded as ‘G‘ for government expenditure.

Add this to the earlier model and we get the model of a 3-sector, open economy, the most common type of economy in the real world. We can see the circular flow for this economy in Figure 4 below.

Figure 4 Circular flow – 3 sector, open economy

What will be the equilibrium condition for this economy? Jot down your answer and then follow the EQUILIBRIUM link.

We could also represent the government separately in this circular flow – here’s an alternative representation of Figure 4. It shows exactly the same flows, but represents them a little differently.

Figure 5 Circular flow – 3 sector, open economy

Why a big box in the middle for government? Just how big a player do you think the government is in the economy? Do some research now and try to find what proportion of national income in your country is taken up by government expenditure. Useful Internet sites are:

When you have found this out, click GOVERNMENT.

Much of the data you will come across in your course is often presented in the form of index numbers and index series. If you do not know what these are then go to the data section of the course where there are worksheets and other materials on index numbers.

What about a centrally planned economy? What will the circular flow look like for such an economy? Think about it, then click CENTRALLY PLANNED.

Yes, another 2-sector economy. The government is the firms, as all firms are owned by the government (state). It may be open or closed.

Look again at the circular flow model for a three-sector economy.

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