Circular Flow of Income

Introduction

An economy refers to an organized system of production and distribution of goods and services for satisfaction of people’s wants. In the economy, the aggregate output and aggregate expenditure are flow magnitudes. Both are determined by the level of aggregate economic activity. To maintain any given level of aggregate economic activity, it is essential that flow of aggregate output and the flow of aggregate expenditure (demand) should be in equilibrium. Any disequilibrium between these two forces will disrupt the flow and will cause changes in economic activity bringing instability to the whole system.

In any economy, the households are the consumption unit and they are also the owners of factors of production – land, labour, capital and organization. The households supply factor services to the firms and a get factor rewards (rent, wage, interest and profit) in return. The firms are the production units, hire factor services from the households, produce goods and services and supply them to the households through the market at a price. In the process goods and services move to the households who purchase them with the income already received by selling the factor services to the firms. In the flow of income and expenditure is complete.

Meaning of Circular flow

Circular flow refers to the continuous flow of income and expenditure in a cyclical manner in the economy from producing units (firms) to consuming units (households) and back from households to the firms and so on. In other words, when income flows from the firms to the households in exchange of productive services and this income again returns to the firms expenditure is made by the households on the goods and services produced by the firms, we call the process circular flow of income.