Circular Flow of Income in a Two Sector Model

Circular Flow of Income:

The modern economy is a monetary economy. In the modern economy, money is used in the process of exchange. Money has facilitated the process of exchange. Money has facilitated the process of exchange and has removed the difficulties of the barter system. Thus money acts as a medium of exchange. The households supply the economic resources or factors to the productive firms and receive in return the payments in terms of money corresponding to the flows of economic resources and the flows of goods and services. But each money flow is in the opposite direction to the real flow.

Circular Income Flow in a Two-Sector Economy:

Real flows include the flow of resources, goods and services. In the upper loop of the figure, the resources such as land, capital and entrepreneurial ability flow from households to business firms, as indicated by the arrow mark. In the opposite direction, money flows from business firms to households as factor payments such as wages, rent interest and profits. In the lower part of the figure, money flows from households to firms as consumption expenditure on the goods and services produced by the firms. In contrast, the flow of goods and services is in the opposite direction from business firms to households. Thus we see that money flows from business firms to households as factor payments, and then it flows from households to firms. Thus there is, in fact, a circular flow of money or income. This circular flow of money will continue indefinitely week by week and year by year.

The flow of money income will not always continue at a constant level. In the year of depression, the circular flow of money income will contract, i.e., it will become lesser in volume, and in years of prosperity, it will expand, i.e., will become greater in volume. This is so because the flow of money is a measure of national income and will, therefore, change with changes in the national income. In years of depression, when national income is low, the flow of money will be small, and in years of prosperity, when the level of national income is quite high, the flow of money will be large.

Circular Money Flow with Saving and Investment:

We will now explain if households save a part of their income, how their savings will affect money flows in the economy. When households save, their expenditure on goods and services will decline to that extent, and as a result, money flow to the business, firms will contract. With reduced money receipts, firms will hire fewer workers (or lay off come workers) or reduce the factor payments they make to the suppliers of factors such as workers. This will lead to a fall in the total incomes of the households. Thus, savings reduce the flow of money expenditure to the business firms and cause a fall in the economy’s total income. Economists, therefore, call savings a leakage from the money expenditure flow. The leakage is again injected into the economy in the form of investment. 

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