It is a model showing flow of goods, services and money from Firm to Household and Households to Firms
As per this Model
Firm Sells all their goods and Services to households
Households sell all their Factor Services (land, Labour etc) to Firms
Firms Pay Factor Payments to Household for use of Factor Service
Households pay Consumption expenditure for use of goods and services
Assumptions
-
There are only 2 sectors in Economy - Firms and Households
(There is no Government or External Sector) -
There is no Savings
Firms spend all their profits on factor services.
Households spend all their expedite on Factor Payments - It is closed economy (no dealing with outside country)
Note
Circular flow denotes both Real Flow and Money Flow
Outer loop denotes Real flow - Exchange of goods and services between firms and Households
Inner loop denotes Money flow - Exchange of money between firms and households
In the Circular Flow of Income
Production activities generate Factor Income (Factor Payments made to households by firm).
This Factor Income is then converted into Expenditure (Consumption Expenditure paid to firms by households).
This flow of income continues as Production is a continuos activity due to never-ending human wants.
It makes the flow of income circular.
Phases of Circular flow of Income
There are three phases in Circular flow of Income:
- Generation Phase - In this phase, firms produce goods and services with the help of factor services.
- Distribution Phase - This phase involves the flow of factor income (in the form of rent, wages, interest and profit) from firms to households.
- Disposition Phase - In this phase, the income received by factors of production is spent on the goods and services produced by firms.
NCERT Questions
Question 2
Why should the aggregate final expenditure of an economy be equal to the aggregate factor payments?
Explain.
View answer
In a 2 sector economy, consisting of only households and firms, households can spend their income only by spending it as consumption expenditure.
As a result the factor payments that the firm made comes back to them in the form of sales revenue.
This way there is not difference between the factor payments and consumption expenditure.
This process will go on continuing.
However, if we include the government and external sectors into the economy.
There will be a leakage in the form of imports, exports, taxes which will lead to a difference between aggregate consumption expenditure and aggregate factor payments.
So, the households will spend less than their factor incomes and firms will receive less amount as revenue, which will lead to a reduction and output and employment levels.
This process will continue in every round, as a result the output and employment levels will keep on decreasing.
Thus, the equality between the aggregate consumption expenditure and the aggregate factor payments is very necessary for the smooth functioning of the economy.
Other Books
Question 1
In a two-sector economy, there is no _____ and _____ sector.
View answer
Government
External
Question 2
In the ___ phase, income received by factors of production, is spent on goods and services produced by _____.
View answer
Disposition
Firms
Question 3
What is the function of households in the circular flow (two-sector model)?
View answer
Households supply factor services to firms and they spend their entire income in the form of consumption expenditure for purchasing goods and services produced by the firms.