National income can be viewed from three interrelated angles, viz., (i) in terms of value of aggregate product, (ii) in terms of incomes accruing to factors of production generates income and (iii)in terms of total expenditure on production. Production generates income and income leads to expenditure on production. Thus, national income can be seen as a circular flow of production, income and expenditure.
In a two-sector economy comprising of only household and business sectors enterprises, the business sector produces goods for which the household sector provides factor services. For these services, in turn, spends these incomes on purchase of goods from the business sector. Thus, income flows from business to household sector and then from household to the business enterprises thereby completing the circular flow of income and expenditure. Since production generates equivalent income, stability requires that income must come back to the entrepreneurs in the form of expenditure so that they receive all that they pay out in the production process.
Saving is a leakage from expenditure stream. This is a part of income that goes from household to the financial market sector (viz., banks, etc.). Investment is an additional to expenditure stream and most investment is financed by borrowing from the financial sector and spent on capital goods. Thus, when S = I, then total income = total expenditure and stability in the economy is maintained.
Introduction of government leads to leakage in income and expenditure through taxes and other compulsory payments made by the households and enterprises to the government. On the other hand, government purchases and other spendings add to total expenditure. Thus, stability in the circular flow requires that government’s revenue receipts are equal to government’s expenditure in the economy. Introduction of foreign trade makes further modifications in the circular flow. Money spent by the household on import of goods does not accrue as revenue to the domestic producer and thus it reduces the expenditure on domestic goods. Exports, on the other hand, means domestic products sold to the rest of the world and thus add to producers’ income. Hence, Import is a leakage and export in an injection in the expenditure Thus, for equilibrium and stability of the circular flow of national income, exports and imports must be equal or net exports (X-M) should be zero.
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