The modern economy is a monetary economy. In the modern economy, money is
used as a medium of exchange. While analyzing the circular flow of income in a
two sector model of the economy, we assume:
Circular Flow Model:
(i) There are only two sectors in the economy,
household sector and business sector.
(ii) The business sector (or the
firms) hires factors of production owned by the household sector and it is the
sole producer of goods and services in the economy.
(iii) The household sector (or the households) is the sole buyer of goods and
services. It spends its entire income on the goods and services produced by the
business sector. They are also suppliers of labor and various of other factors
(iv) The business sector sells the
entire output to households. It does not
store. There are, therefore, no inventories.
(v) There are no savings and investment in the economy.
(vi) The household sector receives income by selling or renting the
factors of production owned by it.
(vii) Government does, not exist for all such practical purposes (No public
expenditures, no taxes, no subsidies, no social insurance contribution, etc.).
(viii) The economy is closed one having no international trade relations.
In this hypothetical economy stated
above, we explain the circular flow of economic life.
Principles of Circular Flow of
In the simple circular flow of income and product, there are two principles
which are involved.
First. In the business transactions, the sellers of goods receive exactly the
same amount which the buyers spend on them.
The goods and services flow in one direction and money payment
flow in the other direction.
Explanation of Circular Flow
of National Income:
In a two sector economy, there are business firms which produce goods and
services. The other sector is households which supplies their factors services
to the firms and also buy goods and services produced by them. The households
supply the economic resources to the firms and receive payments in terms of
money. There is, thus, a flow of money corresponding to the flow of economic
resources. These money incomes are spent by households on goods and services
produced by the firms. With this the money comes back to the firms. This
circular flow of income in fact is the mutual dependence of the two sectors of
Diagram of Circular
Flow of Income:
The circular flow of income in a two sector economy is explained with the
help of figure 23.1.
In this figure, it is shown that the economy consists of two sectors
households and business. In the upper top of this figure, the resources such as
land, capital, labor 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 factors payments such as
rent, wages, interest and profit.
In the lower pipe line, money flows from households to firms as consumption
expenditure made by the households on the goods and services produced by the
firms. The flow of goods and services is in opposite direction from business
firms to households. We, thus, find that money flows from business firms to
households as factor payments and then it flows back from households to firms.
Thus there is in fact a circular flow of income. This circular flow of money or
income continues year after year. This Is how the economy functions.