Explain the circular flow of income with the inclusion of the financial sector

Explain the circular flow of income with the inclusion of the financial sector

*INTRODUCTION:

~ The three sector model is actually an extension of the two-sector model.

~ Apart from households and business firms, it includes the financial sector on account of the savings and investments made by households and firms.

~ Thus, the three sector economy involves factor market, product market, capital market and money market.

*ASSUMPTIONS:

i) There is some amount of savings and investments by the households and the firms.

ii) There is no economic activity by the government.

iii) There is absence of international trade.

iv) Saving is equal to investments.

*ILLUSTRATION:

*EXPLANATION:

~ The above illustration depicts the circular flow of income in a three sectored economy.

~ The three sectors comprise of households, business firms and financial sector.

~ The financial sectors evolves on account of savings and investment made by households and firms.

~ The inner circular flow represents the REAL FLOW of income whereby the households supply the factors of production to the firms in the form of land, labour, Capital and Enterprise.

~ The firms, in return, provide the households with goods and services that are produced by using the above factors of production.

~ The outer circular flow of income represents the MONEY FLOW of income.

~ The money flows from the firm to the households in the form of rent, wages, interest and profits. It is a reward/income for supplying the factors of production to the firms.

~ Similarly money flows from the households to the firms in the form of purchase of goods and services for satisfaction of wants. This is the consumption expenditure of the households that becomes the income of the firms.

~ However, households save a part of their income and thus, the expenditure on good and services decline. So, saving reduce the flow of money expenditure to the firms.

~ but, savings need not reduce the aggregate expenditure as firms undertake investment expenditure on capital goods i.e savings in the economy are converted into investment expenditure through the financial sector.

~ Thus, the circular flow of income and expenditure continue at a steady level as savings = investment.

*CONCLUSION:

~ Thus, the circular flow of income continues when savings and investment are equal.

~ However, any imbalance between savings and investments will affect the circular flow of income when savings are greater than investment, there will be fall in income, output and employment and hence the flow of money will contract. On the other hand, when investments exceed savings, there will be an increase in income, output and employment and hence the flow of money will expand.

~ Thus the circular flow of income will fail to continue at a steady level unless the government intervenes and takes some preventive or corrective measures to ensure stability in the circular flow of income.

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