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Circular Flow of Income in Two Sector Economy


The circular flow of income is the model of the economy in which the major exchanges are represented as flows of money, goods and services etc. between economic agents. The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction.

The circular flow of income can be described in three types of economies. They are:



1.    The Two-Sector Economy

2.    The Three-Sector Economy

3.    The Four-Sector Economy (Open Economy)



1.   The Two-Sector Economy:



This economy considers a simple prototype economy which does not have a government and does not trade with other countries. The only transactions in this economy are:

a)    Households

b)    Firms

Functions of Household:

i.              Factors of production

ii.             Consumption Spending


Functions of Firms:

i.              Production of goods and services

ii.             Payments of factors



Any profit earned by the firms is redistributed to the households. The households are assumed to spend all income on the consumed goods and services produced by the firms



Flow Chart of Two –Sector Economy:

Transaction in two-sector economy is shown the flow chart. The cart shows that the expenses made by the household become the source of income for the business sector or the firms. Firms provide payments to the factors owners (landlord, labor, investors and entrepreneur) for producing factors of production. Further the factor owner spends this income on buying goods and services produced by the business sector, which becomes revenue for the business sector.



                                                  Flow chart of two sector economy



Since the household spend their income, the total money received by business sector will be equal to the income and consumption expenditure of the household sector. Thus Income(Y) = Aggregate Expenditure (consumption + investment).

In this way, an equilibrium state exists in the economy. This can be shown in the diagram below.
Thus circular movement of income and expenditure in the economy continues, leading to equalization in the GDP and GNP.


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  1. The FundadvisorMay 27, 2021 at 5:25 AM

    Amazing post, I got to know something new. The fundadvisor and it can be a great source of knowledge for financial and Business management.

    ReplyDelete

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