In Economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers.
In the very basic model, we have two principal components of the economy:
Firms – Companies who pay wages to workers and produce output.
Households -Individuals who consume goods and receive wages from firms.
The circular flow of income shows connections between different sectors of our economic system. It revolves around flows of goods and services and factors of production between firms and households.
Businesses produce goods and services and in the process of doing so, incomes are generated for factors of production (land, labour, capital and enterprise) – for example wages and salaries going to people in work.
To explain a little bit more, we assume that in a particular economy, there are only two sectors.
2. House holds.
Firms are required to produce goods. Households own the various factors of production. Firms require the services of households to produce goods. The firms hire the services of households to produce goods. These goods are again supplied to the households. When households sector purchases the goods it makes the payments. Similarly firms make the payment in the shape of rent, wages, and interest to the households against their services.
In this way the sum of prices of the goods and services must be equal to the sum of the reward for the services of factors of production.
So income flows from firms to households in exchange for these services and again the expenditure flows from households to firms. The goods which are produced by the firms these are purchased by the household. The flow of income flows from firms to household and flow of expenditure from household to firms will be equal. This is called circular flow of national income.
In the real world it is more complicated. We also add two more components:
Government: The government taxes firms and consumers, and then spends money, e.g. health care and education.
Foreign sector: We sell exports abroad and buy imports. Therefore, there is a flow of money between one country and the rest of the world.
Withdrawals (W) into Circular Flow of Income
Withdrawals are items that take money out of the circular flow. This includes:
Savings (S) (money not used to finance consumption, e.g. saved in a bank)
Imports (M) (money sent abroad to buy foreign goods)
Taxes (T) (money collected by government, e.g. income tax and VAT)
Injections (J) into Circular Flow of Income
Spending that puts money into the circular flow of income.
Investment (I) – Money invested by firms into purchasing capital stock.
Exports (X) – Money coming from abroad to buy domestically produced goods.
Government spending (G) – Government welfare benefits, spending on infrastructure.