Circular Flow of Income

The Circular Flow of Income refers to the flow of income with the exchange of
goods and services in the economy among various sectors. In the basic (two-
factor) circular flow model, money flows from households to firms as
consumption expenditures in exchange for goods and services produced by
firms and then returns from firms to households for the work people do.

Circular Flow of Income represents the flow of money among the different
sectors of an economy.

The two-sector model depicts the flow of

money between households and firms.
 It refers to the cycle of generation of income in the production
process, its distribution among the factors of production, and finally,
its circulation from households to firms in the form of consumption
of goods and services produced by them.
 Households refer to the consumer sector in the economy that
provides factors of production to firms and also does consumption
expenditure on the goods and services produced by the firms.
where,
 Firms refer to the production sector that produces the goods and
services with the help of factors of production and makes factor
payments to the households for their factor service
 Factors of production refer to the inputs which are required for the
production of goods and services. For example Land, Labor, Capital,
and Entrepreneur.
 Factors payments are the income that the supplier of factors of
production gets in return for their service.. For example Rent, Wages,
Interest, and Profits.

Phases Of Circular Flow Of Income

1. Production Phase
 2. Income Phase
3. Expenditure Phase

Phases Of Circular Flow Of Income

1. Generation Phase: In this phase, firms produce goods and services
with help of factors of production. For example production of yarn
from cotton in the textile industry with the help of labor and
machines.
2. Distribution Phase: In this phase, factor income is transferred from
firms to households. For example payment of wages to the labors
for their factor service.
3. Disposition phase: In this phase, income received by the households
is spent on goods and services produced by firms. For example
expenditure by the households to meet the daily requirements

Stock and Flow

Stock
Stock variables are those variables that are measured at a particular point in
time. For example national wealth, capital, money supply, bank balance, raw
material in godown, etc…
Flow
Flow variables are those variables that are measured over a period of time. For
example losses, profits, investment, capital formation, savings, income, etc…

Difference Between Stock And Flow

Types of Flow
Real Flow and Physical Flow
Real Flow refers to the flow of factor services from households to firms and the
flow of goods and services from firms to households.

In Real flow goods and services are exchanged without the involvement of any
money. This flow determines the magnitude of the growth process in the
economy

It is also known as ‘physical flow’.

Money FLow
Money Flow refers to the flow of factor payments to households by firms and the
flow of consumption expenditure from the household to the firm.

It is also known as NOMINAL FLOW. It involves the exchange of money.

Flow Of Income In Two Sectoral Economy

TWO SECTORAL Economy or SIMPLE Economy assumes only two sectors:
Household and Firms.
A closed economy consists of households, firms, government, and the financial
sector and not the rest of the world.

An open economy consists of households, firms, the government, and the rest of

the world.

Following are some assumptions are taken for a better understanding of this
system: –

 There are only two sectors in an economy i.e. households and firms.
 The household sector provides factor services and makes
consumption expenditure on goods and services.
 Firms produce goods and services and make factor payments to the
household sector.
 There are no savings in the economy which means all income
earned by the households is spent on consumption expenditure and
the firms are also not saving their profits.
 The outer loop shows the real flow of income and the inner loop
shows the money flow of income.
 So there is a circular and continuous flow of money income as the
entire factor payment is received back with firms through
consumption expenditure.
 This circular flow of income continues as production is a continuous
process due to never-ending human wants. It makes the flow of
income circular.