Circular Flow of Income

It is a simple economic model that shows the movement of goods and services and factors of production between producers and consumers within a economy. It also refers to the flow of goods and services among the various sectors of the economy balanced by the monetary payments made in exchange for those goods and services. It is called so because the movement of income and expenditure continues throughout the economy and repeats itself forming the circular flow of income. In the circular flow

model the expenses made by one sector becomes the income for the other sector and the goods and services produced by the firms is demand made by the economy.

Assumptions:

1.     Household spend their whole income on goods and services produced by the firms.

2.     Firms produce goods and services demanded by the household only.

3.     In case of two or three sector closed models, there is no inflow or outflow of income and expenditure from any outside sources.

4.     In the case of four sector, the foreign sector consists of imports and exports of goods and services made by the firm.

There are two kinds of flows generated in transactions :

1. Real flow: It includes the flow of factors of production from the household sector to the business sector and the corresponding flow of goods and services from the business sector to the household sector.

2. Monetary Model: It includes the flow of rent, wage, interest and profit to the household sector from business sector for hiring factors of production and on the other hand, the consumption payment flow from household to the business sector.

Agents of Circular Model: 1. Household, 2. Business, 3. Government and 4. Foreign

Importance of Circular Flow of Model:

1.     It helps in analyzing the problem of disequilibrium.

2.     It helps in analyzing the effects of leakages and injection.

3.     It creates a link between consumer and producer.

4.     It creates a network of markets.

5.     It helps to measure the inflationary or deflationary.

6.     It highlights the importance of monetary and fiscal policies.