What is circular flow of income?

Economy and Finance

What is circular flow of income?

28 Aug 2023 Zinkpot 284

Circular flow of income is defined as the flow of payments and receipts for goods and services and factor services between different sectors of the economy.
It is a basic parameter of macroeconomics.
Understanding the circular flow: A large number of goods and services are produced in an economy every year. These goods and services are produced in production units by combining different factors of production.
Producers purchase the factors services to produce goods and services. The output generated via production is distributed as factor income to the owners of factors of production in the form of various factor incomes like wages, rent, interest, and profits.
The factor incomes earned or generated are spent on the purchase of goods from the production units. These expenditures generate input for the producers.
As such, production gives rise to income, income gives rise to expenditure and expenditure gives rise to income again and this process continues.
The flow of goods and services is matched by an equal, but reverse money flow.
For instance, if a labourer sells his labour service to a producer and thereby earns a wage income of Rs 10,000 a month, there will be a money flow of Rs 10,000 in the form of wages from the producer to the labourer and at the same time, the flow of labour service of the same value from the labourer to the producer.
There is a constant flow of income and expenditure among different sectors of the economy The economy is divided into four sectors:
Household sector: Households are the main owners of the factors of production, land, labour and capital. They sell the services of these factors to producers and in return receive their income, from that income, they purchase goods and services from the producer.
Business sector or firms: The term business sector, producers and firms are used interchangeably. Firms hire services of factors of production from households to produce commodities that they sell to households and other firms, governments or to other countries.
Government: Government is taken in the sense of general government so as to exclude govt commercial enterprise. The general government gets its income largely through taxes imposed on households and the business sector in the form of direct and indirect taxes.
Rest of the world: Differing sectors of the economy have transactions, not only with each other but also with foreign countries i.e. the rest of the world. The country exports/imports goods and services to/from other countries.
In order to simplify the circular flow of income, the above-mentioned four sectors are combined into three models of circular flows:
Two sector model consisting of the household and the business sectors;
Three sector model comprising the household, business and government sectors, known as the closed economy model
Four sector model consisting of households, the business sector, the government sector and the rest of the world, known as the open economy model.
The entire economic system can be viewed as a circular flow of income and expenditure. It shows how different sectors of the economy are interrelated and interdependent.
The magnitude of these flows determines the size of national income can be measured via output, income, and expenditure phases of circular flow of income.