Q.(a) Explain the two sector circular flow model with diagram.

(a) The two-sector circular flow shows income moving continuously between households and firms through real and money flows. (b) The trade cycle passes through prosperity, recession, depression and recovery.

(a) Two-sector circular flow model (with diagram, described in words):

The economy is assumed to have only two sectors — households and firms — with no government, no foreign trade and no saving (all income is spent).

• Households own the factors of production (land, labour, capital, organisation) and supply them to firms.
• Firms use these factors to produce goods and services and sell them to households.

Two flows operate, in opposite directions, forming a circle:

1. Real flow: Factor services flow from households to firms; goods and services flow from firms to households.
2. Money flow: Firms pay factor incomes (rent, wages, interest, profit) to households; households pay consumption expenditure to firms for goods and services.

(Diagram in words: draw two boxes — Households on one side, Firms on the other. An outer loop shows the money flow: factor payments from firms to households at the top, consumption expenditure from households to firms at the bottom. An inner loop shows the real flow: factor services from households to firms, and goods and services from firms to households — the two loops run in opposite directions.)

Since households spend all they earn, total income = total expenditure = total output, and the flow continues without interruption. This is the simplest model of how income circulates in an economy.

(b) Phases of the trade cycle:

A trade cycle (business cycle) is the recurring rise and fall in economic activity over time. It has four phases:

1. Prosperity (Boom): High output, employment, income, investment and prices; full or near-full use of resources; optimism among businessmen. The economy reaches a peak. …