Importance of Circular flow of income
The concept of the circular flow gives a clear-cut picture of the economy. We can know whether the economy is working efficiently or whether there is any disturbance in its smooth functioning. As such, the circular flow is of immense significance for studying the functioning of the economy and for helping the government in formulating policy measures.
1. Study of Problems of Disequilibrium: It is with the help of circular flow that the problems of disequilibrium and the restoration of equilibrium can be studied.
2. Effects of Leakages and Inflows: The role of leakages enables us to study their effects on the national economy. For example, imports are a leakage out the circular flow of income because 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.
3. 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.
4. Creates a Network of Markets: As a corollary to the above point, the linking of producers and consumers 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.
5. Inflationary and Deflationary Tendencies: Leakage or injections in the circular flow disturb the smooth functioning of the economy. For example, 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 and prices, thereby leading to a deflationary process in the economy. On the other hand, consumption tends to increase employment, income, output and prices that lead to inflationary tendencies.
6. Basis of the Multiplier: Again, if leakage exceed injections in the circular flow, the total income becomes less than the total output. This leads to a cumulative decline in employment, income output and prices over time. On the other had, 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.
7. 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 equality between saving and investment comes about through the credit or capital market.
The credit market itself is controlled by the government through monetary policy. When saving exceeds investment or investment exceeds saving, money and credit policies help to stimulate or retard investment spending. This is how a fall or rise in prices is also controlled.
8. 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 (1+G). S+T represents leakages from the spending stream which must be offset by injections of I+G into the income stream. If S+T exceed I + G, government should adopt such fiscal measures as reduction in taxes and spending more itself. On the contrary.
If 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.
9. Importance of Trade Policies: Similarly, imports are leakages in the circular flow of money because they are payments made to be 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.
10. Basis of Flow of Funds Accounts: The circular flow helps in calculating national income on the basis of the 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 possesses much theoretical and practical significance in an economy.
