CIRCULAR FLOW OF INCOME
Introduction
Endless and recurring desires of humans have
transformed the production process into a continuous
one.
During the process of production, various factors of
production, such as - land, labour, capital, enterprise, etc.
combine together to produce various types of goods and
services.
During the process of production, a sector of an economy
depends on other sectors to fulfil its various
requirements/needs.
This dependence of one sector on other sectors is termed
as intersectoral dependence.
And the Intersectoral dependence results in circular flow
of income along with goods/services.
An example of intersectoral dependence or circular flow:
o Firms produce various types of goods and services
through the collective efforts of various factors of
production provided by the household sector.
o In turn firms pay rent, wages, interest, and profit to
various factors of production. This is known as factor
income.
o The household sector uses this money to purchase goods
and services produced by firms.
Circular Flow of Income (Two Sector Model)
What is Circular Flow?
Circular flow of income refers to the continuous flow of
production of goods and services, income, and expenditure in
an economy.
Two Sectors Circular Flow of Income
Two sectors of circular flow of income are- firms and
households.
Firms
Firms hire/purchase factor services (land, labour
and capital) from households to produce goods and
services. In return, households receive factor
payments in the form of rent, wages, interest and
profit for rendering productive services. Thus,
income is generated.
Households
Households spend their income on purchase of goods and
services (produced by firms) to satisfy their wants.
Expenditure by households goes back to the firms in
form of their income. This. Continuous process
completes the circular flow of income.
Principles of Circular Flow of Income
There are two basic principles involved in circular flow of
income:
Expenditure of one is the income of other:
Circular flow of income is based on the axiom that one's
expenditure is other's income. As in any exchange process, the
seller/producer receives the same amount which the
buyer/consumer spends.
Equality of real flow and money flow:
Goods and services flow in one direction whereas the money
payment to acquire those goods and services flow in the
opposite direction.
Concept of Leakage and Injection
Leakage
Leakage refers to the amount of money which is withdrawn
from the flow of income. For example, savings by households,
taxes by firms and import payments.
Injection
Injection refers to the amount of money that is added to the
flow of income. For example, investments, government
expenditure and income received from exports.
Components of Circular Flow of Income
There are two components of circular flow of income, i.e.,
real or physical flow and money or nominal flow.
Real or Physical Flow
Real flow refers to the physical flow of goods and services
between firms and households.
In other words, the term real flow means flow of factor
services (land, labour and capital) from households to firms
and flow of goods and services from firms to households.
Money or Nominal Flow
Money flow refers to the flow of money in the form of factor
payments and consumption expenditure. other words, the term
money flow means the flow of factor payments from firms to
households for factor vices and households to firms in the
form of consumption expenditure.
