Circular Flow of Income

An economy can be pictured as a continuous circular flow between two sets of decision-makers: households, who own factors of production (land, labour, capital, entrepreneurship), and firms, who use those factors to produce goods and services.

• In the real flow, households supply factor services to firms, and firms supply goods and services back to households.
• In the money flow, firms pay households factor incomes (rent, wages, interest, profit) in return for those services, and households spend that income buying goods and services from firms, so money flows back to firms as revenue.

Because every rupee of production becomes someone's income, and every rupee of income is eventually spent (or saved/invested, which is itself a form of expenditure), the value of production, the value of income generated, and the value of expenditure incurred in an economy over a year must, in principle, be equal. This identity — Production = Income = Expenditure — is exactly why national income can be measured from three different starting points, giving rise to the three methods covered later in this chapter. …