Question

Make a detailed study of circular flow of national income in two-sector economy.

Answer 1

The circular flow of income refers to the continuous flow of goods and services and money income between households and firms in the economy. In a two-sector model, there are only two sectors,  households and firms, and no government or foreign trade.

Assumptions:

• The economy consists of only households and firms.
• Households own all factors of production (land, labour, capital, enterprise).
• Firms produce only goods and services.
• Households spend their entire income on consumption (no saving).
• There is no government and no foreign sector.
• The economy is in equilibrium.

Process of Circular Flow:

A. Real Flow: Households supply factor services to firms. Firms use these services to produce goods and services which are supplied back to households. 

B. Money Flow: In return for factor services, firms make factor payments (wages, rent, interest, profit) to households. Households then spend their income on goods and services produced by firms (consumption expenditure).

4. Equilibrium Condition:

In a two-sector economy: National Income (Y) = National Expenditure (C) = National Output (O)

That means total production by firms total income of households = total expenditure of households.