The essentials
The circular flow of income shows how money and goods move continuously between the sectors of an economy. In the simplest two-sector model there are only households and firms. Households own the factors of production (land, labour, capital, entrepreneurship) and supply them to firms. Firms use these factors to produce goods and services and pay households factor incomes: rent, wages, interest and profit. Households spend this income on the goods produced by firms, so the money returns to firms. There are therefore two flows moving in opposite directions: a real flow of factor services and goods, and a money flow of factor payments and consumption spending.
Because every rupee spent by one sector is received by another, the value of output produced, the income generated and the expenditure on that output are equal. This is the basis for the three methods of measuring national income.
Key points
- Leakages (withdrawals): savings, taxes and imports take money out of the circular flow.
- Injections: investment, government spending and exports add money to the flow.
- Savings of households reach firms through the financial market (banks), which lends them for investment.
- A four-sector model adds the government (taxes, transfers, purchases) and the rest of the world (exports, imports, factor incomes).
- In the simple two-sector model with no saving, consumption expenditure equals factor income.
Exam tips
Learn which items are leakages and which are injections; it is a favourite one-mark question. Be ready to say which way an arrow points: factor services go from households to firms, factor payments from firms to households.
Common mistakes
- Confusing the real flow with the money flow.
- Thinking that savings are always lost; they return as investment if the financial market channels them to firms.