Circular flow of income in a two-sector economy

The two-sector model and its assumptions. The circular flow diagram shows how income moves round a simple economy with only two sectors: households and firms. It assumes there is no government, no foreign trade and no saving. Households own the factors of production (labour, land, capital and enterprise); firms hire these factors and produce goods and services.

The two markets. The diagram is drawn as two loops joining the two sectors:

• The goods and services market (the upper loop). Firms sell goods and services to households; households pay for them.
• The factor market (the lower loop). Households supply factor services to firms; firms pay them wages, rent, interest and profit, which are the households' incomes.

The real flow and the money flow.

• Real flow: factor services go from households to firms, and goods and services go from firms to households.
• Money flow: factor payments go from firms to households, and consumption spending goes from households back to firms as their sales revenue.
• The two run in opposite directions: each real flow is matched by a payment for it.

Why the flow is circular. Two features of the model close the loop. Households use every rupee of income to buy goods and services, and firms hand on every rupee of sales revenue as wages, rent, interest and profit; nothing is saved, taxed or spent abroad, so nothing drops out on the way. Follow one rupee: the wages a Ludhiana textile mill pays its workers return to it, and to other firms, when those workers buy clothes and food, and those firms then pay out the same money as factor incomes. Since every payment for output is someone's income, the size of the flow can be measured at any of three points (as total factor incomes, as total spending, or as the value of the output bought) and in this simple economy the three come to the same figure. And because production and payment start again each period, the same total keeps going round, year after year.

Conclusion. In the two-sector model, production creates incomes and incomes create the spending that buys the production; real and money flows go round the economy in opposite directions and, with no saving, government or trade, income equals expenditure equals output.