CIRCULAR FLOW OF INCOME [FULLY EXPLAINED]

What is a circular flow of income?

Q1. Explain the meaning and phase of the circular flow of income.

Ans. Circular flow of income refers to the cycle of generation of income in the
the production process, its distribution among the factors of production and
finally, its circulation from households to the production units in the form of
consumption expenditure on goods and services produced by this unit.

Phases of circular Flow of Income
There are 3 different phases (generation, distribution, and disposting) in
circular flow of income as shown in the given diagram.

• Generation Phase : In this pahse, firms produced goods and serives
  with the help of factor service.
• Distribution Phase : This phase involves the flow of factor income (rent,
  wages, interest and profit) form firms to the households.
• Disposition Phase : In this phase, the income received by factors of
  production is spend on the goods and services produced by firm.

Q2. Difference between Stock and Flow

Q3. Explain types of the circulation flow
Ans. There are two types of circulation flows : (i) Real flow (ii) Money Flow Real Flow
Real flow: refers to the flow of factor services from households to firms and the corresponding flow of goods and services from firms to households. It is also known as physical flow.
Households provide factor services to the firms which in turn, provide goods and services to them as a reward for their productive services. Since there is an exchange of goods and services between the two sectors without any money involvement, such a flow is known as real flow.

Money Flow
Money flow refers to the flow of factor payments from firms to households for their factor services and the corresponding flow of consumption expenditure from households to firms for the purchase of goods and services produced by the firm.s It is also known as Nominal flow.
Here firms make factor payments to households for their factor services and households spend this income on the purchase of goods and services produced by the firms. As it involves the exchange of money between the two sectors, such flow is known as money flow.

Q4. Difference between Real Flow and Money Flow

Q5. Explain Circular Flow in a simple economy (Two-Section Economy)

Ans. A simple economy assumes the existence of only two sectors i.e, the household sector and the firm sector.

Households are the owners of factors of production and consumers of goods and services.

Firms produce goods and services and sell them to the household.

It is the simplest form of a closed economy, in which there is no government sector and foreign trade.

To make our analysis simple, we make some assumptions :

1. There are only 2 sectors in the economy : Households and Firms. It means, there is no government and foreign sector.
2. Hosuehold sector supplies factor services only to firms and the firms hire factor services only from housholds.
3. Firms produce goods and services and sell their entire output to the households.
4. Households receive factor income for their services and spend the entire amount on consumption of goods and services.
5. There are no savings in the economy, i.e., neither the households save from their incomes, nor the firms save from their profit.

The Circular Flow in the Two-Sector economy can be better understood with the help of figures.

The outer loop of the diagram shows the real flow, i.e, flow of factor services from households to firms and corresponding flow of goods and services flow from firms to households. The inner loop shows the money flow, i.e., flow of factor payments from firms to households and the corresponding flow of consumption expenditure from households to firms. It must be noted that the entire amount of money, which is paid by firms as factor payments is paid back by the factory owners to the firms. So, here is a circular and continuous flow of money income.

In the circular flow of income, production generates factor income, which is converted into expenditure. This flow of income continues as production is continuous activity due to never-ending human wants. It makes the flow of income circular.

Leakages and Injections

Leakage: Leakages refer to the withdrawal of money from the circular flow. When households and firms save a part of their incomes, it leads to a leakage from the circular flow of income.  As a result, it is not available for spending on currently produced goods and services. It means leakage reduces the flow of income.

Injection: Injection refers to the introduction of income into the circular flow. When households and firms borrow money from external sources like financial institutions, it adds to their income.  Such additional income does not result in immediate expenditure. So, injections increase the flow of income.

It must be noted that equilibrium is achieved when injections are equal to Leakage.