- This is the continuous movement of income between the households (providers of factors of production) and the firms (producers of goods and services).
- The factors of production are received from households.
- The firms pay the rewards of such factors to the households (expenditure to the firms and income to the households).
- The households in turn use the income to buy the goods and services produced by the firms (expenditure to households and income to firms).
Assumptions/features of circular flow of income
- Existence of two sectors only. It is assumed that the economy has only two sectors that is households and firms. The households provide the factors of production while firms are involved in the production of goods and services.
- Total spending by households. It is assumed that the households spend all their income on the goods and services produced by the firms i.e. no savings.
- Total spending by the firms. It is assumed that the firms spend the money received from the sale of goods and services to pay for the rewards of production factors.
- Lack of government intervention. The government does not influence how the firms and households carry out their activities. Such interventions are in the form of taxes, price controls among others.
- Closed economy. Exports and imports do not exist in such an economy.
Factors affecting the circular flow of income
- The factors can either lead to increase in income and expenditure (injections) or lead to a reduction in the volume of flow (withdrawals).
The factors include the following:
- This takes place when the households do not spend all their income on the purchase of goods and services. This reduces the income to be received by firms hence savings is a withdrawal from the circular flow of income.
- Taxation reduces the amount of money available for spending therefore it is a withdrawal/leakage from the circular flow of income.
- Government expenditure. The government may buy goods from the firms or provide subsidies. This will translate in to an injection into the circular flow of income.
- When firms put more capital into the production, output will increase hence an increase in income (injection).
- When goods and services are bought from other countries, money will be spent hence a reduction in the circular flow of income (withdrawal).
- Through exports, a country is able to receive money from other countries (injections)
- Government spending