Scribd
Upload
9 views1 page

circular flow of income

The document explains the Circular Flow of Income in a two-sector economy, consisting of households and firms, where households provide factor services and firms produce goods and services. Income generated from production is distributed as factor payments to households, which then spend their entire income on goods and services, completing the circular flow. It also outlines three methods to calculate national income: production, income, and expenditure methods, emphasizing that the same amount of money circulates without any leakage.

Uploaded by

kanica bathla
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
9 views1 page

circular flow of income

The document explains the Circular Flow of Income in a two-sector economy, consisting of households and firms, where households provide factor services and firms produce goods and services. Income generated from production is distributed as factor payments to households, which then spend their entire income on goods and services, completing the circular flow. It also outlines three methods to calculate national income: production, income, and expenditure methods, emphasizing that the same amount of money circulates without any leakage.

Uploaded by

kanica bathla
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 1

r ~~ ===~---•

Circular Flow of Income (T-


.1wo- Sector Mo del) 0

I orcUJ
~ ow of mcome refers to flow of incon
d * •h
.
le across different sectors of an economy in a circular way.
In a dose ecodnflomy wit out a government, external trade or any savings there are only two sectors, namely,
olds an urns. '
househ
useholds are owners of factors of production. Th
11
pO • (' th r ' ey
ro•,,ide factor services m e rorm of labour, capu · al ,
P
!alld and entrepreneurship)
. . to the firms (prod.ucmg •
units), Income 1s generated m production units in the
forrn of value of total final goods and services produced
in the economy.
fjrrns distribute the entire income generated to make
factor payments (in the form of wages and salaries,
' interest, rent and profit). Thus, factor payments flow Fadllr Servk:eS

from firms to households. Circular flow of income in a two sector economy

Aggregate value of final goods and services produced = Aggregate factor payments

In this simplified economy, there is only one way in which the households may dispose off their earnings - by
spending their entire income to buy the goods and services produced by the firms. Households do not save,
they do not pay taxes to the government - since there is no government, and neither do they buy imported
goods since there is no external trade in this simple economy. So, households buy goods and services from
firms for which they make payment to the firms. Thus, consumption expenditure (i.e., spending on goods and
services) flows from households to the firms, making the circular flow of income complete. Hence, circular flow
of income in a two sector economy is based on the axiom that one's expenditure is other's income.
The entire income of the economy, therefore, comes back to the producers in the form of sales revenue. There is
no leakage** from the circular flow of income.

Aggregate factor payments = Aggregate final expenditure on purchase of goods and services

Note that the same amount of money is moving in a circular way. Thus, national income can be calculated by
:hree methods, which give us the same value.
I. Production method: Product method measures aggregate value of final goods and services produced by
all the firms in the economy during a year (Annual flow at AJ.
2. Income method: Income distribution method measures aggregate factor payments made in the econo m y
during a year (Annual flow at BJ.
3. Expenditure method: Expenditure method measures the aggregate final expenditure on goods an~
services in the economy during a year (Annual flow at CJ.

Top Tip
Nominal Flow and Real Flow
• Nominal Flow/Money Flow is the flow of factor payments and payments for goods and se rvices between households
and firms.
• Real Flow is the flow of factor services and the flow of goods and services between households and fi rms.

You might also like