CIRCULAR FLOW OF INCOME

 Circular flow of income 

  An economy is an integrated system of production , exchange and consumption . In carrying out these activities , people buy and sell goods and services . Income generated in the production process flows in a circular manner. It is circular because there is no beginning or an end. 

 Circular flow of income refers to flow of money income or the flow of goods and services across different sectors of an economy in a circular flow . 

Circular Flow of income in a Two- Sector economy: To present the flows of income and expenditure , the economy is divided into two sectors : 

( a ) Household sector , 

( b ) Firm sector . It is a model of private closed economy .

 Features of household sector are :

 ( a ) They are owners of all factors of production . 

( b ) The total income received is wages plus rent plus interest plus profit . 

( c ) They are the consumers of goods and services , i.e. , they make consumption expenditure to the business sector . 

 Features of firm sector are : 

 ( a ) They hire factors of production from the household sector . 

( b ) They produce and sell goods and services to the households and receive income from them . 

( c ) They make factor payments to the household sector . shows the circular flow in a two - sector economy . The upper half shows the factor market and the lower half the commodity / product market . Each market generates two flows : a goods ( or real ) flow and money flow . Money flow is shown by a dashed or broken line . Each sector is a buyer and a seller .

Thus , in our simple economy , 

1. Total production of goods and services by Firms = Total consumption of goods and services by Household sector .

 2. Factor payments by Firms Factor incomes of Households . 

3. Consumption expenditure of Households Income of Firms sector . 

4. Real flow of production and consumption of Firms and Households = Money flow of income and expenditure of Firms and Households .

Circular Flow of income in a Three-Sector of an economy :

 The three sectors of an economy are - Household , Firm and Government . Features of government sector are :

 1. Government sector receives direct taxes from the household sector and indirect taxes from the firm sector .

 2. Government sector makes transfer payment to the household sector and gives subsidies to the business firm sector ( like food subsidy , fertiliser subsidy , etc. ) . 

3. Government's savings goes to the capital market and government borrows from the financial system . 

Circular flow of income in afour -sector economy :

 Four - sector economy is an open economy . In an open economy , there are imports and exports with rest of the world . Today , all economies are open economies . The 4 - sector circular flow model is shown in 

Features of external or rest of the world sector are : 

1. Foreign sector makes payment to the firm for  exports to rest of the world .

 2. Foreign sector gets payments for imports made to firm sector . 

3. Household sector exports factor services to rest of the world sector .

 4. External sector makes net transfer payments and net factor payments to the household sector . Whereas factor payments ( rent , interest , profit , wages / salaries ) are related to the factor services ; transfer payments are not .