(ii) Indirectly via investment expenditure by the business sector. (i) Directly via consumption from the households to the business sector, and Thus savings which flow into the capital market are taken away by the business sector for investment and the circular flow of money is maintained in the economy.įigure 2 shows how the circular flow of money is altered by the inclusion of saving and investment. On the other hand, business firms borrow funds from the capital market for making investment. Such savings of consumers and firms are not hoarded but are invested in bonds, shares, debentures, etc. But they keep a part of it in the form of undistributed profit. Similarly, business firms do not spend their entire income from the sale of goods. Rather, they save a part of their income for a variety of motives. The consumers who represent the household sector do not spend their income wholly in purchasing goods and services. In fact, the household and business sectors do not spend their entire money income. In the circular flow of money, saving is one of the leakages and investment is an injection. Production equals sales or supply equals demand, and the economy will continue to operate at this level in a circular flow of money. On the other hand, the flow of money as consumption expenditure on the purchase of goods and services by the household sector is shown to go to the business sector by an arrow in the upper portion of the diagram.Īs long as income payments by the business sector for factor services are returned by the household sector to purchase goods, the circular flow of income payments and consumption expenditure tends to continue indefinitely. The circular flow in a two-sector economy is depicted in Figure 1 where the flow of money as income payments from the business sector to the household sector is shown in the form of an arrow in the lower portion of the diagram. In this way, money flows in a circular manner from the business sector to the household sector and from the household sector to the business sector in the economy. Money so received is, in turn, spent by the household sector to by goods produced by the business sector. Thus in the first instance, money flows in the form of such income payments as rent, wages, interest and profits from the business sector to the household sector when the former buys the services of the factors of production to produce good.
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