The circular flow of income
The circular flow of income and spending shows connections between different sectors of an economy. It shows flows of goods and services and factors of production between firms and households. The circular flow also shows how national income or Gross Domestic Product is calculated. The circular flow of income can also be defined as an economic model in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow analysis is the basis of national accounts and hence of macroeconomics.
Moving on, the circular flow of income describes the flow of payments from businesses to households in exchange for labor and other productive services and the return flow of payment s from household to businesses in exchange for goods and services.
Please note the following points:
- For easy understanding, a two sector economy which involves households and firms will be used. The household supply factors of production (input) to firms which need them for production purposes.
- In return the household will be paid salaries and wages, interest, rents by the firms which constitute their incomes.
- The Income is then used by the households to purchase goods and services produced by the firms. This pattern of consumption expenditure made by households constitutes income for a firm which leads to the formation of income inflow.
Factors Affecting Circular Flow of Income
- Injection: Injection of fund into the circle is an increase in the incomes of households and firms beside their normal processes of selling productive resources and manufactured goods.
- Savings: Savings constitute the part of income that is not spent immediately. They have the tendency of reducing expenditure of the household or firms.
- Withdrawal: Withdrawal has the tendency of reducing the fund in the circular flow of income.
- Investment: investment brings about an additional income leading to injection into the circular flow of income.
- Aids and grants: Aids and grants from government or other sources increase the volume of fund in the circular flow of income.
- Import and Export: While import involves the expenditure on foreign goods and services leading to withdrawals from circular flow of income, exports provide funds leading to injection into the circular flow of income.
