1.2 Circular Flow of National Income

The blog post ‘Circular Flow of National Income’ will explore the flow of money, goods, and services in an economy, emphasizing the interaction between households, firms, and other economic sectors. It will explain the key components, illustrate the different models of the circular flow, and highlight its significance in understanding economic activities. This topic is equally important for the students of economics across all the major Boards and Universities such as FBISE, BISERWP, BISELHR, MU, DU, PU, NCERT, CBSE & others & across all the business & finance disciplines.

Circular Flow of National Income

Circular Flow of National Income is an economic model that shows how money moves and circulate in the economy. It shows the interdependence of different sectors of the economy. It shows the redistribution of the income between households and production sector. Here we are going to use two sector economy in which there are two players in the economy households and Firms.

Key Components:

Households

Households provide factor of production such as land, labour, capital and organization or entrepreneurship to firms. With the combination of these factors of production, goods and services are made and sold in the market. After getting price or value of the products, value is distributed among households as a reward or return against factors of production given by the households in the form of rent, wage, interest and profit. Households perform two functions here, first they provide factors to the firms and second, they purchase goods and services from them. Factors of production and their rewards are given below in the table 1.2

Table 1.2 Factors of Production and their Rewards

Factors	Rewards
Land	Rent
Labour	Wage
Capital	Interest
Organization/Entrepreneurship	Profit

Firms:

Firms, on the other side produce goods and services with the help of factors of production employed by households, sell these goods and services to the households and receive income in return. Here firms also perform two functions, first they produce goods and services with the help of factors employed by the households and second, they distribute the income to the households as return to the factors.

Here firms are on the production side and households are on the consumption side. Here flow has two types, on is called real flow and second one is called money flow.

Real Flow

Households provide factors such as land, labour, capital and organization to the firms and firms provide goods or services to the households. Here flow is called real flow.

Money Flow

Firms, in return make factors payments or incomes to the households against factors, they employed and households spend that income to buy goods and services. This flow is called money flow.

Figure 1.2 Circular Flow of National Income

In above diagram outer loop has flow from households to the firms in the form of factor service and spending.
As we know that, households provide factors of production to the firms and also spend their factor income as spending to buy goods and services produced by the factors of production.
Inner loop represents the flow of factor payments and goods and services from the firms to the households.
Firms produce goods and services with the help of factors employed by the households and presented to the households to buy.
Generated income against selling goods and services is distributed among the households as a reward or return of factors employed by them.
Here flow of factor services from households to firms and flow of goods and services from firms to households is real flow.
Flow of factor payments from firms to households and spending by households is money flow.