Posted by Anjali Kaur on Jun 15, 2020

Circular Flow Of Income: In The Two-Sector model

This is an important topic from National Income which we should know if we are good economics experts. The Circular Flow Of Income shows how income circulates in any economy. In this post, I will only explain the basic two-sector model as a starter. Let’s see.

What is the Circular Flow of Income in a Simple Economy?

In a simple economy, that is, where we have only two sectors namely: producer and household. It refers to the cycle of a generation of income in the production process and its distribution among various factors of production. It also includes the provision of service and payments from the Household sector to the Producer sector.

How does the Income Circulate in a Simple Economy?

Let’s understand this step by step:

1. Factor services such as land, labor, capital, and entrepreneurship flow from household to producer sector, and this type of circulation where the money is not involved is called Real Flow.
2. Factor payments such as rent, wages, interest, and profits flow from the producer sector to household for their services and this type of circulation where the money is involved is called money or nominal flow.
3. Final goods and services, flow from the producer sector to the household sector and it is the real flow as money is not involved.
4. Final consumption expenditure on goods and services flow from household to producer sector in exchange for goods and services, as it involves payment for the goods purchased by the household. This is money flow.
5. We assume that there is No savings and investments. So, the total production of goods and services by the firms is equal to the total consumption expenditure on goods and services by the household.
   1. Factor payments by the firms should be equal to the factor income of the household.
   2. Consumption expenditure of household should be equal to the income of the producer sector

As shown below is the diagrammatic presentation of the circular flow of income in a simple economy with two sectors:

L- Labor who receives wages in return for their services

L- Land on which rent is paid as a payment.

K- Capital on which interest is paid

E-Entrepreneurship who receives final profit

Photo by Sharon McCutcheon on Unsplash

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