(a) What is real flow?
(b) What is the relevance of the financial sector in the circular flow of income? Explain .
(a) The flow of goods and services and factors of production between different sectors of an economy is called real flow.
(b) The financial sector is a combination of commercial banks, the stock market, and RBI. It helps in mobilising savings from households for investment by the firms.
Two Sector Model with Financial Sector:
Savings are the retained income that is not used in the purchase of goods and services. Savings reduces the amount of money that households can spend on goods and services. Thus, savings are the withdrawal or leakage from the circular flow of income. Most of the households either keep them in the form of deposits with banks or put them in mutual funds and other investments etc. Financial institutions such as banks, mutual funds, insurance companies are collectively called the financial sector. Thus, the household’s savings flow into the financial sector of the economy.
Firms use the money (money available from the financial sector) to make investments. Investment is the expenditure that is incurred on capital goods. Investment is also termed as capital formation. Investment increases the productive capacity of the economy in the future.
Since the investment expenditure increases the flow of income, they are called injections into the circular flow of income.