Tuesday, August 25, 2009

Circular Flow of Income

National Income can be measured either by income or expenditure or output approach. The statistical data will remain the same in all cases. Aggregate output is the result of the cooperation and coordination among the factors of production land, labour capital and organization which is remitted back to then in the form of their remuneration rent, wages, interest and profit. The income is spend on the purchase of consumer goods and a part of that is saved which is invested on the capital goods and investment helps in the production of consumer goods which are purchased and consumed by the same factors into market. Thus income slops no where. It rather takes the circular flow. We will discuss circular flow of National Income in two sector and three sector economies.


The circular flow is based upon two principles:

1. As a result of each economic transaction the seller gets how much is spent by the buyer.

2. If goods and services have a flow towards a particular direction, the money has also a flow towards other directions.

In the two sectors economy what so ever is produced by producer is sold out to the consumers, while consumers spend all of their earnings on the consumption of the goods produced by producers. The consumer or household provide services of four factors to the producers. Against such services, the factors of production get remunerations.

In following figure we have assumed an economy where there are households and firms. The flows in the upper part of the figure represent goods market. Here the firms provide final goods to the consumers. While household makes the payments to the producers of such goods and services in the form of money. While the flows in the lower part of the figure represent factor markets. Here the households provide services of factors of production to the firms.

What so even the factors earn against their services, its summation represents National Income. The summation of goods produced also represents National Income. Again the total expenditure made by household also represents National Income.

Thus we find that National Income is a flow moves from household to firms and from firms to household. The such movement of income is given the name of irregular flow of National Income.


Three sector Economy consists of consumers, producers and government. In the presence of government, there will be government purchases. Hence in product market, government expenditures will also be included. In such situation, the national output will consists of monetary value of final consumption, final investment goods and final government purchases. For the production of three above mentioned goods and services, the factors of production have to be employed. Then three rises the resource or factors market. Against such factors of production the wages, rent, profit and interest have to be period. The summation of such factor payments is known as National Income at factor cost. Here the size of National Income will be greater than two sector economy. In three sector economy households and firms pay tax to the government. The consumers make the savings which create financial market. The firms get the loans from this financial market and make investment of produce capital goods. More over government also gets loans from money market. The amount collected through taxes and gotten through financial market is spent by the government on government purchases. All this shows that National Income moves like a circular flow from consumers to producers vice versa. However on such economy there are government expenditures which also generate GNP.


1 Responses to “Circular Flow of Income”

Anonymous said...
October 10, 2011 at 7:35 AM

simple n gud notes...

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