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Definition of Circular Flow Model:

A simple circular flow model of the macro economics containing two sectors (business and household) and two markets (product and factor) that illustrates the continuous movement of the payments for goods and services between producers and consumers. The payment flow between the two sectors and two markets is conveniently divided into four segments representing consumption expenditures, gross domestic product, factor payments, and national income.

The modern economy is a monetary economy. In the modern economy, money is used as a medium of exchange. While analyzing the circular flow of income in a two sector model of the economy, we assume:

Assumptions:

(i) There are only two sectors in the economy, household sector and business sector.

(ii) The business sector (or the firms) hires factors of production owned by the household sector and it is the sole producer of goods and services in the economy.

(iii) The household sector (or the households) is the sole buyer of goods and services. It spends its entire income on the goods and services produced by the business sector. They are also suppliers of labor and various of other factors of production.

(iv) The business sector sells the entire output to households. It does not store. There are, therefore, no inventories.

(v) There are no savings and investment in the economy.

(vi) The household sector receives income by selling or renting the factors of production owned by it.

(vii) Government does, not exist for all such practical purposes (No public expenditures, no taxes, no subsidies, no social insurance contribution, etc.).

(viii) The economy is closed one having no international trade relations.

In this hypothetical economy stated above, we explain the circular flow of economic life.

Principles:

In the simple circular flow of income and product, there are two principles which are involved.

First. In the business transactions, the sellers of goods receive exactly the same amount which the buyers spend on them.

Second. The goods and services flow in one direction and money payment flow in the other direction.

Explanation with Example:

In a two sector economy, there are business firms which produce goods and services. The other sector is households which supplies their factors services to the firms and also buy goods and services produced by them. The households supply the economic resources to the firms and receive payments in terms of money.

There is, thus, a flow of money corresponding to the flow of economic resources. These money incomes are spent by households on goods and services produced by the firms. With this the money comes back to the firms. This circular flow of income in fact is the mutual dependence of the two sectors of modern economy.

Diagram:

The circular flow of income in a two sector economy is explained with the help of following diagram:

In this figure, it is shown that the economy consists of two sectors:

(1) Household Sector.

(2) Business Sector.

In the upper top of this figure, the resources such as land, capital, labor and entrepreneurial ability flow from households to business firms as indicated by the arrow mark. In opposite direction to this, money flows from business firms to the households as factors payments such as rent, wages, interest and profit.

In the lower pipe line, money flows from households to firms as consumption expenditure made by the households on the goods and services produced by the firms. The flow of goods and services is in opposite direction from business firms to households.

We, thus, find that money flows from business firms to households as factor payments and then it flows back from households to firms. Thus there is in fact a circular flow of income. This circular flow of money or income continues year after year. This is how the economy functions.