Two Sector Model Without Saving and Investment

• The two sector model consists only households and firms (production units).
• This model exists in a hypothetical economy where there is no government and which has no interaction with rest of the world.
• Therefore, there ate only two sectors — household sector and business sector.
• The household sector owns all the factors of production. This sector sells the factor services to the firms and receives income from them in the form of wages, rent, interest and profits.
• The money payments made by firms to house holds are cost expenditure for the firms and factor incomes for the households.
• Firms use this factor inputs to produce goods and services, which are sold to the households.
• The household sector pays for these goods in the form money and firms receive money payments from the household.

Two Sector Model of Circular Flow of Income without savings[/caption]

• Given figure explains the money flow and real flow in a two sector economy.
• In the upper loop, factor services flow from household to the firms, which is indicated by solid arrow. This is real flow.
• In return, the money flows from the firms to households as factor payment which is indicated by dashed line or arrow. This is the money flow.
• In the lower loop, goods and services produced by the firms flow from the firms to the households, as indicated by the solid arrow. This is the real flow.
• The households pay for these goods and services with money which creates money flow, indicated by dashed arrow.
• The flow of factor services in upper loop gives rise to a reverse money flow and similarly the flow of goods and services in lower loop give rise to money flow in opposite directions.
• The outer circle represents the real flow, indicated by solid lines, which consists of flow of factor services from households to firms and flow of goods and services from firms to households.
• The inner circle represents the money flow indicated by dashed line, which consists of flow of factor incomes from firms to households and flow of money expenditure on goods and services from households to firms.
• By combining both types of money flows, we get circular flow of money from the firms to households and from households to firms.
• Similarly, we get a circular flow of goods and services by combining both types of real flows.
• Since the two sector model is without saving and investment, the households spend all their incomes on buying consumer goods produced by the firms, and firms distribute all their income from sale to households as factor income.
• At this condition the circular flow of income will remain constant and there would be equilibrium in circular flow of income.
• The total money receipts of the firms will be equal to the total income of the households. Similarly total income of the household is equal to the expenditure of the firms on the purchase of factor services. Then there would be equilibrium in the circular flow of income.
• Thus in a two sector model:

1. Total production of goods and services by firms Ξ Total consumption of goods and services by households
2. Factor income of the households Ξ Factor payment by the firms
3. Income of the firms Ξ expenditure of the households

B. Two Sector Model With Saving and Investment :

• For a simple two sector model we have assumed that there is no saving either by household or by firms. Households spend all their income on goods and services produced by firms and firms distribute all their receipts to the households as factor income.
• But in reality, they save a part of their income. Households save part of their income for either old age or to meet future expenditure like marriage of their children etc. Similarly, the firms also save a part of their receipts in the form of depreciation provisions and for undertaking investment.
• A part of the income which is not spent by households on consumer goods and services is called savings.
• To keep our analysis simple, we assume that all the savings are done by the households.
• Households services income from the firms and pass back only a part of it, through consumption expenditure and a part of the income is saved. This way the consumption expenditure is reduced and the level of circular flow of income falls.
• Therefore, saving represents the withdrawal or leakage of expenditure from the circular flow of income between household and firms.
• Withdrawal or Leakage : Withdrawal or leakage is the amount of money which is withdrawn from the flow of income. It is not passed on to circular flow of income and and therefore not available for expenditure. Leakage reduce the flow of income in the economy.
• Savings may be used for undertaking investment expenditure.
• Investment refers to expenditure on producer goods which help in producing other goods in the production process.
• Expenditure on plant, machinery, etc. are example of investment expenditure. These capital goods are not purchased by the consumers, rather they are purchased by the firms only.
• If we expand our two sector model to incorporate capital goods, the firms produce two types of goods.
• First type of goods are consumer goods, which are sold by the firms to the households. The second type of goods are capital goods (or investment goods) , which are sold by the firms that produce them to the other firms that use them.
• Investment expenditure creates income for the firms that produce capital goods and factors used in the production of these goods.
• This income does not arise from the expenditure of the households, thus it results in an addition to the circular flow of income and hence the level of income rises. It can be said that investment expenditure is an injection into the circular flow of income.
• An injection is the amount of money which is added to the flow of income. It is an exogenous addition to the income of the firms or households. Injections increase the flow of income in an economy.
• To simplify our analysis, we assume that the saving done by only households and the firms do not retain anything as undistributed profit.
• This implies that the investment undertaken by firms is financed through savings of households.
• Households and firms interact with each other largely through financial institutions (capital market) like banks, insurance companies, mutual funds etc. Financial institutions intermediate between savers and investors or lenders and borrowers.
• In our two sector model with saving and investment we assume that whatever is saved by the households is deposited with financial institutions (capital market) and the firms take loans from these financial institution to undertake investment.
• Thus, households are the net lenders as they save part of their income and firms are net borrowers since they borrow finds to undertake investment.
• Thus, savings of the household sector flow to the firms for undertaking investment through the medium of capital market.

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Two Sector Model of Circular Flow of Income with Savings[/caption]

• Above diagram show the circular flow of income in two sector model with saving (leakage ) and investment (injection) .
• This illustration is based on the assumption that the household doesn’t spend all their income in consumption of goods and services but a part of it is saved to the financial institution (capital market).
• Thus a new sector, known as capital market is added.
• A part of income of households, flow towards the firms as consumption expenditure and a part of the income flows to capital market in the form of savings indicated by dark lines labeled ‘S’.
• The capital market act as a mediator which co — ordinates the saving and investment activities of the households and the business firms.
• The household supply saving to the capital market and the firms, in turn obtain investment funds from the capital market. The investment flow is shown by the dark line labeled ‘I’ .
• Since, saving is a withdrawal or leakage of income from the circular flow, the level of circular flow of income falls down.
• On the other hand, investment is an injection of income in circular flow, the level of circular flow of income results in an increase or rise.
• The point at which the saving (S) becomes equal to investment (I), the circular flow of income is said to be in equilibrium.
• Therefore, the equilibrium condition of the circular flow of income in two sector model is S = I
• When the savings by the households exceeds investment by the firms ( S> I ) the income flows declines.
• Excess of saving over investment implies that whatever income leaks out from the circular flow in the form of saving is not offset by an equivalent injection in the form of investment. This decreases the level of income.
• When investment by the firms exceeds savings by the household (I> S), the income flow increases.
• Excess of investment over savings implies that whatever income leaks out from the circular flow of income in the form of savings is more than offset by an injection in the form of investment. This pushes up the level of income in the economy.

Originally posted on : ecogradeshelp.com