Question

Explain the two-sector model of the circular flow of National Income.

Answer 1

The circular flow of income refers to the process whereby an economy’s money receipts and payments flow in a circular manner continuously through time. The following figure explains the circular flow of income and expenditure in a two-sector model.

1. The two sectors in the two-sector model are households and firms.
2. The upper half of the diagram represents the factor market, while the lower half represents the commodity market.
3. The factors of production flow from households to firms. The firms use these factors to produce goods and services required by households.
4. Thus, goods flow from households to firms and from firms back to households. It is called product flow.
5. Similarly, money flows from firms to households in the form of factor payments such as rent, wages, interest, and profit. Households use this income to purchase goods and services.
6. Thus, money flows from firms to households and back to firms. It is called money flow.
7. In the circular flow of income, production generates factor income, which is converted into expenditure.
8. This flow of income continues because production is a continuous activity driven by never-ending human wants. It makes the flow of income circular.