The circular flow in a simple two-sector economy

The two sectors and the assumptions. The simple model has only two groups of decision makers:

• Households, who own the factors of production (labour, land, capital and enterprise) and buy goods and services for consumption;
• Firms, who hire those factors to produce goods and services and sell them to households. The model assumes there is no government, no trade with other countries and no saving, so households spend their whole income on what the firms produce.

The four flows. The diagram is drawn as two boxes, Households and Firms, joined by two loops of arrows: one loop through the market for goods and services, the other through the market for factors of production.

The real flows and the money flows run in opposite directions round the circle: whatever moves one way as a good or a service is matched by a payment moving the other way.

Why the flow is circular. The payments the firms make to factor owners are the households' income. Households spend all of it on the firms' output, so the whole income comes back to the firms as sales revenue, and there is no leakage from the system. In the next period the firms again produce, pay the factors, and the money goes round again; spending, output and income can grow from period to period while the flow stays circular. Production creates income, income creates the spending that buys the output, and that spending finances the next round of production.

Conclusion. Because nothing leaks out, the value of output, the total of factor incomes and total spending are equal in this model; for example, if Indian firms in this simple economy pay out ₹100 crore as wages, rent, interest and profit in a year, households spend that ₹100 crore back on the firms' goods, so aggregate income can be measured either as total spending or as the value of what firms produce.