Explain the circular flow of income.
Circular Flow Model in a Two-Sector Economy
Circular flow of income refers to the unending flow of activities such as production, income generation and expenditure involved in all the sectors of the economy.
In a simple economy, there are the economic activities of firms and households. People from households render factor services to firms and firms hire factor services from households. Households spend their earned income completely on consumption. Products which are produced by firms are sold to consumers, assuming that there is no external trade and government in an economy.
In the diagram, factor services provided by households to firms are shown by inner arrows of the upper portion and factor payments made by firms to households are shown by inner arrows of the lower portion. With this income, households purchase goods and services of the firms which are shown by outer arrows of the upper portion and firms deliver goods and services to households as shown by outer arrows of the lower portion.
- Total production of goods and services by firms is equal to the consumption of goods and services by households.
- Factor payments by firms are equal to the factor incomes of the household sector.
- Consumption expenditure of the household sector is equal to the income of the household sector.
- Money flows are opposite to real flows because factor service flows from households to firms are real flows, and the factor payments made by firms to households are money flows.
- This circular flow model helps to estimate the national income of a country in the following ways:- 1. Aggregate the income of all the factors of production (inner arrows of the lower portion) or Aggregate the expenditure incurred by all the sectors (outer arrows of the upper portion)