Circular flow of income refers to the cycle of generation of income in the production process to the distribution of income among the factors of production and finally the circulation from household to firms in the form of consumption expenditure on goods and services produced by firms. 

Phases of circular flow of income 

  1. Generation Phase : Firms Produce
  2. Distribution Phase : Flow of Factor Income 
  3. Disposition Phase: Income received by factor of production is spent on Goods and Services. 
Sectors involved in Circular Flow :- 

1.Household Sector : Consumption of Goods and Services and provider of factor services

2. Producing Sector : Production of goods and services 

3. Government : Taxation and subsidies

4.Rest of the world : Exports and Imports 

Type of Circular Flow : 

Real Flow :- It is the flow of goods and services between firms and households. It involves exchange of goods and services . It is difficult and called physical flow . 

Money Flow :- It is the flow of money between firms and households. It involves exchange of money . It is not difficult plus it is called as nominal flow. 


Circular Flow in a Simple Economy :- 

A simple economy assumes the exercise of only two sectors, i.e., Household Sector and Firms Sector. 

  • Households are the owners of factors of production and consumption of Goods and Services 
  • Firms produce goods and services and sell them to households
  • It is the simplest form of closed economy , in which there is no government sector and foreign trade. 
Assumptions :- 

  • Only two sector- households and firms 
  • Household sector supplies factor services only to firms . Firms hire factor services only from households. 
  • Firms produce goods and services and sell their entire output to the households. 
  • Households spend the entire amount to consumption of goods and services. 
  • There is no saving in the economy , i.e., Neither the household save from their income nor the firms save from their profits. 
Conclusion 

  • Total Production = Total Consumption 
  • Factor Payment = Factor Income 
  • Consumption Expenditure = Factor Income 
  • Real Flow= Money Flow .
We will discuss circular flow of Income in two sector model with Financial Market and 3 sector Economy in  next post.