Hence, financial institutions perform the role of intermediaries amidst savers and investors. Further, the firms also borrow money from the financial system for making an investment, which results in the injection of money into the circular flow. The amount is saved in the financial institutions like banks. This means that the total income of the economy comes back to the firms in the form of sales revenue.Ĭircular Flow of Income in a Two-Sector Economy with the Financial Systemįirms and households often save a part of their income, which results in leakage from the circular flow of income. of households is equal to the sales revenue of the firm. Consumption expenditure on food, clothing, health, education, etc.Factor payments by firms are equal to factor incomes of households.Aggregate production of goods and services by the producers is equal to the Aggregate consumption of goods and services by consumers.There is no leakage, in the form of savings or taxes.There are two types of market in this economy, – product market and factor market.No third sector (government or foreign) is present in the economy.All the goods and services produced by the firms are sold to households.Entire Income earned by the households is spent on consumption.Households provide factor services to the firm and firms receive factor services from households.In a two-sector economy, there are two major sectors or groups, – producers which are referred to as firms and consumers, i.e.The figure shown below represents the circular flow of income in a two-sector economy: To indicate the circulation of income and expenditure in a two-sector economy, the economy is broadly divided into two groups – Household and Firms. Hence, there is the disposition of income in this phase.Ĭircular Flow of Income in a Two-Sector Economy Disposition Phase: Finally, the factor incomes received is invested in the purchase of goods and services for the purpose of consumption.Hence, there is a distribution of income. Distribution Phase: In this part, the firm makes factor payments to the households, in the form of rent, wages, interest and profit, for the factor services provided by them.As it leads to the generation of income, it is called a generation phase. Production Phase: In this phase, goods and services are manufactured by the firms, by making use of inputs, for the purpose of production of goods and services.In general, circular flow is bifurcated into three major phases which are: Now the money received is spent on buying goods and services produced by the firm. Households provide factor services to the firm, in the form of land labour, capital and entrepreneur and get factor payments for the same, in terms of money.

Money Flow: Money Flow or Nominal flow involves the exchange of goods and services for money.

Real Flow: Otherwise called as Product Flow or Output Flow, it implies the movement of factor services and, goods and services among different sectors of the economy.

There are two types of circular flow, explained hereunder:

Also makes payment to the other sectors for the import of goods and services.

External Sector: It is the foreign sector which receives money for the export of goods and services to the firms, household and government.

Also, the government makes factor payments to the households and provides public utility services to the general public.

Government Sector: It is the third sector of the economy which earns revenue in the firms, households and foreign sectors, in the form of taxes, fees, duties, and proceeds from the sale of goods and services.

As the inputs are owned by the households, factors payments are made to them in the form of rent, salary and wages, interest and profit. land, labour, capital and entrepreneur, so as to produce goods and services. Producer Sector: All the producer firms and establishments fall under this category.

factors of production and renders factor services to the producer sector. The household sector owns the inputs, i.e. Household Sector: This sector covers consumer of goods and services, who buys them for their personal consumption.

Circular flow of income