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, government expenditure, exports, imports etc. are shown on diagrams in the form of currents and cross-currents in such a manner that national income equals national expenditure.
Importance of the Circular Flow
The concept of circular flow gives a clear cut picture of the economy. We know whether the economy is working efficiently or whether there is any disturbance in its smooth functioning.
- Study of Problems
It is with the help of circular flow that the problems of disequilibrium and the restoration of equilibrium can be studied.
- Effects of Leakages and Inflows
The role of leakages enables us to study their effects on the national economy. For instance, imports are a leakage out of the circular flow of income for the reason that they are payments made to a foreign country. To stop this leakage, government should adopt appropriate measures so as to increase exports and decrease imports.
- Link between Producers and Consumers
The circular flow establishes a link between producers and consumers. It is through income that producers buy the services of the factors of production with which the latter, in turn, purchase goods from the producers.
- Creates a Network of Markets
As a corollary to the above point, the linking of producers and consumer through the circular flow of income and expenditure has created a network of markets for different goods and services where problems relating to their sale and purchase are automatically solved.
- Inflationary and Deflationary Tendencies
Leakages or injections in the circular flow disturb the smooth functioning of the economy. For instance, saving is a leakage out of the expenditure stream. If saving increases, this depresses the circular flow of income. This tends to reduce employment, income, prices thereby leading to a deflationary process in the economy.
Conversely, consumption tends to increase employment, income, productivity and prices that lead to inflationary tendencies.
- Basis of the Multiplier
Again, if leakages exceed injections in the circular flow, the total income becomes less than the total output. This leads to a cumulative decline in employment, income, productivity and prices over time.
Conversely, if injections into the circular flow exceed leakages the income is increased in the economy. This leads to a cumulative rise in employment, income, output and prices over a period of time. In fact, the basis of the Keynesian multiplier is the cumulative movements in the circular flow of income.
- Importance of Monetary Policy
The study of circular flow also highlights the importance of monetary policy to bring about the equality of saving and investment in the economy. The credit market itself is controlled by the government through monetary policy. When saving exceeds investment or investment exceeds savings, money and credit policies help in stimulate or retard investment spending. This is how a fall or rise in prices is also controlled.
- Importance of Fiscal Policy
The circular flow of income and expenditure points toward the importance of fiscal policy. For national income to be in equilibrium desired saving plus taxes (S + T) must equal desired investment plus government spending (I + G). S + T represents leakages from the spending stream which must be offset by injections of I + G exceed S + T, the government should adjust its revenue and expenditure by encouraging saving and tax revenue. Thus the circular flow of income and expenditure tells us about the importance of compensatory fiscal policy.
- Importance of Trade Polices
Likewise, imports are leakages in the circular flow of money for the reason that they are payments made to a foreign country. To stop it, the government adopts such measures as to increase exports and decrease imports. Thus the circular flow points toward the importance of adopting export promotion and import control policies.
- Basis of Flow of Funds Accounts
The circular flow helps in calculating national income on the basis of flow of funds accounts. The flow of funds accounts are concerned with all transactions in the economy that are accomplished by money transfers. They show the financial transactions among different sectors of the economy, and the link between saving and investment and lending and borrowing by them. To conclude the circular flow of income processes much theoretical and practical significance in an economy.
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