CHAPTER-1 - Circular Flow of Income

Q1

Solution:

Market for
goods and
services

Circular
Firms or
suppliers Flow Households

Diagram

Market for
factors of
production

Firms in the market hire or need labor to produce their products

hence they go to market for factors of production. When in this
market they hire labor from households or hire something on rent
from households, they need to pay them with something in return
which becomes the income for households. After producing goods
and services firms or suppliers go to the market for goods and
services as sellers and sell their product. Here households from the
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money earned by working for firms buy according to their choice
and preferences and hence agoin giving the money back to the firms
or suppliers and hence the cycle continues. Firms also get their
income which they earn as profit and use it to again in the market
for factors of production to produce products. This is what is known
as circular flow of income.

Q2

Solution:

The three phases of circular flow of income are:

• Production phase: In this phase of the circular flow of income,

producers or firms make use of required factors of production
used from Market for factors of production to produce their
goods and services.
• Income phase: This phase of circular flow of income refers to
transferring of income to households from firms or producers
in return for rendering their services to firms to produce
different goods and services.

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 • Expenditure phase: This can be thought as income generation
phase for firms as income is transferred from households to
firm in return of goods and services offered by households.

Q3

Solution:

Difference between stock and flow is given below:

Stock Flow

1 When a quantity is measured at a When a quantity is

particular time then its known as stock. measured with respect
to specific length of
time then its known
as flow.

2 Stock is static in nature. It is dynamic in

nature as it needs to
be calculated over a
period.

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 Examples include: national wealth, Examples include:
water in reservoir National income,
water in river

Q4

Solution:

Clearly from the circular flow diagram, we see two kinds of flow
moving in different direction:

1. Real flow: This is the flow of inputs and outputs. This is the
flow in which households provide factor services to firms and
firms provide goods and services to households. This is known
as real flow because real factors of production and goods and
services are exchanged in this flow.
2. Money flow: This is the flow of money. In this part, money
flow from firms to households in return of factors of
production and from households to firms in return of goods and
services.

Q5
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Solution:

Real Flow Money Flow

Exchange of real Exchange of money

inputs and outputs takes place in
i.e. factors of money flow.
production and
goods and services
take place in real
flow.

There exists lot of Quite less or almost

difficulties that no such difficulties
need to be need to overcome in
overcome in money flow.
exchange of goods
and services.

It is also called It is also called

physical flow nominal flow
because it mainly because it mainly
involve exchange of

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factors of involve exchange of
production and money.
goods and services.

Q6

Solution:

Government as a sector plays combination of following roles in an

economy:

• As a regulator of economic system: As a regulator of economic

system, government make required kind of policies and also
reforms the economy according to its needs. It also takes
responsibility to try and implement these policies and punish
those who do not follow them.
• As a producer and supplier of private goods and services: A
government also produces some goods and services and sells
them in the market hence making a profit. Here the government
acts as a private enterprise.
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• As a supplier or producer of social or public goods: There are
certain goods and services like education, healthcare, foods etc.
which are essential everyone. Hence government try to
distribute these kinds of services free of cost or at subsidized
rate to the needy and this loss to the government has to be
taken by the whole economy through way of government
taxing other goods and services.

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