Circular Flow of Income

The circular flow of income is a model showing how income and expenditure move continuously between the different sectors of an economy, and it is the conceptual foundation for why the three measurement methods (product, income, expenditure — next section) must all arrive at the same total.

Two-sector model. In the simplest possible economy, there are only two decision-making units — households (who own all factors of production) and firms (who produce goods and services). Two flows run simultaneously and in opposite directions:

• The real flow — households supply land, labour, capital and enterprise to firms; firms, in turn, supply finished goods and services back to households.
• The money flow — firms pay households factor incomes (wages, rent, interest, profit) in return for the factor services received; households, in turn, spend that income buying goods and services from firms, so the money returns to firms as revenue.

Because every rupee of expenditure by one sector becomes income for the other, this flow is genuinely circular and, in a simple two-sector economy with no saving or government, keeps flowing at a constant, unchanging level year after year.

Leakages and injections. A real economy is never this simple — some part of household income is saved rather than spent, some is paid to government as taxes, and some spending leaks abroad as payments for imports; these are called leakages, because they withdraw money from the circular flow. Offsetting them are injections — spending that enters the flow from outside current household consumption: firms' investment (spending funded partly by household savings channelled through banks/financial markets), government spending, and exports (foreign spending on domestically produced goods). …