EAST POINT SCHOOL

STUDY NOTES
CLASS XII (2023-24)

CHAPTER 1 MACRO ECONOMICS

CIRCULAR FLOW OF INCOME

STOCK & FLOW

Stock refers to any quantity that is measured at a particular point in time, while flow is
referred to as the quantity that can be measured over a period of time. Both the stock and
flow are interdependent on each other.

Stock Flow

Stock is defined as a variable that is Flow is defined as a variable which is

measured at a particular point in time measurable over a period of time

Stock does not have a time dimension Flow has a time dimension

Stock is static in nature Flow is dynamic in nature

Stock influences the flow, Flow influences the stock,

as such greater amount of capital as in increased flow of money supply in
will lead to greater flow of services. an economy results in increase in the
quantity of money.

Example: Example:
Bank deposits, capital, wealth, population Capital formation, income, interest on
capital, depreciation

MEANING OF CIRCULAR FLOW OF INCOME:

It refers to the cycle of generation of income in the production process, its distribution
among the factor of production, its circulation from households to firms in the form
of consumption expenditure on goods and services produced by them.

PHASES IN CIRCULAR FLOW OF INCOME

• In the First Phase (Production / Generation Phase), the f i rm produces goods

using factors of production(Land, Labor, capital and Enterprise)

• In the Second Phase (Income/ Distribution Phase), the f i rms make factor
payments (Rent, wages, Interest & Profit) to the household for providing factor
services.
 • In Third Phase (Expenditure/Disposition Phase), the households spend the amount
received by f i rms in purchasing their products.

DIF F ERENT TYPES OF CIRCULAR F L O W ARE- REAL FLOW AND

MONEY FLOW

Real Flow - It refers to the flow of factor services (land, labor, capital, and enterprises)
from household to fi rms and the fl ow of goods and services from f i rms to
households. It is also known as ‘Physical Flow’.

Money Flow - It refers to the flow of factor payments (Rent, wages, interest, and
profit) from firms to households for providing factor services and flow of
consumption expenditure from households to firm for providing goods and services. It
is also known as Nominal f l ow.

Difference between Real Flow and Money Flow

BASIS REAL FLOW MONEY FLOW

It is the flow of money between firms

It is the flow of goods and services and households.
Meaning between households and f i rms.

Kind of It involves the exchange of money.

Exchange It involves the exchange of goods
and services.
Difficulty in
Exchange These may be the difficulty of the There is no such difficulty in the case of
Barter system in exchange of money flow.
goods & factor services.

other name It is also known as 'Physical flow’ It is also known as 'Nominal Flow'
CIRCULAR FLOW IN TWO SECTOR ECONOMY

In a simple two-sector economy, there exist only 2 sectors i.e. household and firms,
where households provide factors of production (Land, Labour, Capital, and Enterprise)
and consumer goods & services made by the firm and sell them to households.

Assumptions:
• There are only 2 sectors in the economy. Households and Firms.
• There are no savings in the economy, i.e., neither the households save from their
incomes, nor do the firms save from their profits.
• There is no government.
• It is a closed economy.
Explanation :-

Real flows of resources, goods and services have been shown in the diagram. In the upper
loop of this figure, the resources such as land, capital and entrepreneurial ability flow from
households to business firms as indicated by the arrow mark.

In opposite direction to this, money flows from business firms to the households as factor
payments such as wages, rent, interest and profits.

In the lower part of the figure, money flows from households to firms as consumption
expenditure made by the households on the goods and services produced by the firms, while
the flow of goods and services is in opposite direction from business firms to households.

Thus we see that money flows from business firms to households as factor payments and then
it flows from households to firms. Thus there is, in fact, a circular flow of money or income.

This circular flow of money will continue indefinitely week by week and year by year. This
is how the economy functions. It may, however, be pointed out that this flow of money
income will not always remain the same in volume. In year of depression, the circular flow of
money income will contract, i.e., will become lesser in volume, and in years of prosperity it
will expand, i.e., will become greater in volume. become lesser in volume, and in years of
prosperity it will expand, i.e., will become greater in volume.

Conclusion:-

There are no savings in the economy, i.e. neither the household saves from their incomes,
not the firm saves from their profits.
In the given diagram, it can be seen that households are providing factor services in
exchange for factor payment and f i rms are providing goods & services to households
in exchange for consumption expenditure.

Total Production = Total Consumption

Factor Payment = Factor Income
Consumption Expenditure = Factor Income
Real Flow = Money Flow

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