Circular Flow

Circular Flow of Products

How you control the entire production process

Market is a very common term used by all of us on a daily basis. Any place enabling buyers and sellers of a particular good/service to interact with each other is called market. If there is a place where buyers and sellers of sugar are coming together and trading with each other, it will be called a sugar market. Similarly, if buyers and sellers of furniture are trading with each other on an online portal, then that portal is also a furniture market.

Suppose you want to set up a cloth manufacturing unit. First thing that you would need is a piece of land to setup the factory. Once you have the land, you need capital. By capital, we are referring to related infrastructure like factory building, machines and software systems. Finally, you would be needing people to work in your factory, called labor. These are the three essential things that are always required for production and are called factors of production. Now the next question, where will you obtain them from? You would be buying these factors from other individuals. You can very well argue that you can buy them from other firms as well, but ultimately somebody would have bought it from individuals.

Let’s divide the whole economy into two parts, firms and households. All land, capital and labour ultimately belongs to households, let’s consider these households as individual families. Firms will be buying these 3 factors of production from households. So we have firms who are the buyer’s, households are the seller’s and factors of production as the product. As per our definition of market,  this setup would be called a factor market.

Let’s now revisit our example where you were trying to setup a cloth manufacturing unit. Suppose, now the factory is set up and you begin manufacturing. Who will buy your products? Again it’s the households (individuals) who would be buying your products in the cloth market. Let’s broaden our example and think about who would be buying all the finished goods manufactured in the economy, it will be the households who would be buying these products. Thus, in finished goods market, firms are the sellers and households are the buyer’s.

As we saw, firms buy factors of production from households in factor market. Then they manufacture finished goods using these factors of production and sell it back to households in finished goods market. Full circular process can be seen in the figure below.


Let’s now try and understand how money flows in the whole process.

Circular Flow of Income

Spend.. it's all coming back to you

In the previous article, “Circular flow of products” we saw how products flow in the economy. Firms buy factors of production from households in the factor market and sell finished goods back to them in the finished goods market.

When firms buy factors of production (land, capital and labor) from the factor market, they need to reimburse households for the same. Thus, in factor market money is flowing from firms to households. Money spent by firms is their cost of production and earnings for the households. In the finished goods markets, firms are selling their products to households, so money is flowing from households to firms. As shown in the diagram below money and products flow in opposite directions, money moves clockwise and products flow anti clockwise. The cumulative amount spent by households is equal to the revenue of the firms. The difference between the amount earned by firms in the finished goods market and the money spent by firms in the factor market is the firm’s profit.


The diagram also makes it obvious that expenditure of one entity is equal to total income of another; applying the same working to the entire economy, total expenditure in the economy is always equal to the total income.

Let’s talk a little more about the income received by households. In the factor market, households earn various kinds of income from firms. Income received for renting out land is termed rent. In return for labor provided by household’s, they receive salary/wages and capital earns interest. It is easy to understand how land would earn rent and labor would earn wages/salary, but understanding how capital earns interest is a little difficult.

Let’s now see how capital, which we earlier defined as machinery, tools and technology earns interest for households.

Leakages in the Circular Flow

How your savings finance corporate investment

To complete our understanding of circular flow, lets now learn about leakages from the same. 3 new entities will now be introduced into the circular flow to explain how they create leakages.
leakages-cf-chart1.Introducing Government

The first entity that is being introduced is Government and it is at the center of the circular flow. Government collects taxes from both individuals and firms. A part of the money received by individuals in factor market, in exchange for land, labor and capital, will be collected by the government as tax. Similarly, a part of the money received by firms in return for finished goods will be collected by the government as corporate tax. Government collects taxes so that the amount can be spent for public welfare by creating public goods. Public goods are goods and services available and useful to all members of the society. This usually includes roads, ports, railways, schools & colleges, hospitals etc.   

2.Introducing External Sector

External sector is linked to the finished goods market. Foreign entities buying finished goods manufactured in a country, say India, i.e. exports, results in injection of money into the economy. Similarly, Indians buying foreign finished goods, i.e imports, results in money flowing out of the economy.

3.Introducing Financial Sector

Financial sector is linked to the factor market. In our previous article, we mentioned that expenditure by firms on capital items like machinery, tools and technology in factor market results in interest income for households. Households earn rent and wages from factor market. A part of this earning is saved in banks for future needs and only remaining balance is spent in finished goods market. This act of saving, results in a leakage and money flows out of the circular flow. Firms borrow money from banks in order to fund their capital related expenditure. This way money is again injected into the economy and in the process firms pay interest to banks for borrowing money. Banks pass on some part of that interest earned to households, in return for parking their funds. Thus households are saving funds and depositing the same in banks. This kitty is then lent out by banks to firms, to fund their capital needs. So in a roundabout way households enable firms to buy capital and in the process earn interest. Banks facilitate the entire process.

Now that our understanding of circular flow is complete, we can easily use the same to learn how GDP is measured in any economy.


Measuring GDP

The recipe

Understanding how to measure gross domestic produce (GDP) becomes very easy after learning circular flow of income. We recommend reading our previous three articles on circular flow of products and money before continuing on. As discussed in an earlier article, GDP is the value of final goods and services produced domestically in a given time period. When we say GDP of India was USD 2.3 trillion in financial year 2015, we mean that total value of all goods and services produced in the Indian economy between April 2014 and March 2015 was USD 2.3 trillion.

In order to measure GDP, we need to calculate the expenditure incurred on producing all the goods and services. Obviously, goods and services produced in the economy will get consumed generating income for producers. From our previous article on circular flow of income we know that income is equal to expenditure. So if we can measure the total spending on goods and services in the economy, we will be able to arrive at the total GDP figure. Hence we can either use the total expenditure or total income approach to calculate total GDP.

Circular flow - measuring GDP

Let’s discuss the expenditure approach. From the above diagram, we can see that there are 4 major spenders in the economy. Households are spending on purchasing goods and services produced by firms, firms are spending on their factor requirements, Government is spending to create public goods and finally foreigners are spending to buy domestic goods.

Total Expenditure = Household expenditure on goods and service (C) + Firm expenditure on capital and other factors (I)+ Government’s expenditure on public goods (G)+ Foreigners net expenditure on exports (X-M)

GDP = C + I + G + (X – M)

Here, C is the consumption by households, I is defined as the investment by firms, G is the government expenditure and X-M is export minus imports. This is how GDP is measured in the expenditure approach.

If any of the above 4 things increase, GDP of the country will also increase. If households are consuming more because of rising levels of income, then GDP will increase. If firms are investing more, because borrowing money has become easy due to low interest rates, then GDP will increase. If Government is spending more on public goods, then GDP will increase. Finally, if exports are rising faster than imports, even then GDP will increase.

The above concept will become clearer in the next posts. Read on.