explain circular flow of income

Circular flow of income refers to the unending flow of activities such as production, income generation and expenditure involved in all the sectors of the economy.

Three Phases of Circular Flow

 The flows of production, income and expenditure form circularity with no end and beginning. Thus it is called circular flow.  Production aspect states the flow of goods and services in the economy or the process of value adding. Income or distribution aspect states the distribution of income in terms of wage, rent, interest and profit. Expenditure or disposition aspect states the disposal of income in terms of consumption expenditure or investment expenditure.

 Two-Sector Economy without Financial Market

In a simple economy, there are firms and household sectors economic activity. People from households render factor services to firms and firms hire factor services from households. Households spend their earned income completely on consumption. Products which are produced by firms are sold to consumers. Assume that there is no external trade and government in an economy. Total production of goods and services by firms are equal to the consumption of goods and services by households. Factor payments by firms are equal to the factor incomes of the household sector. Consumption expenditure of household sector is equal to income of the household sector. Money flows are opposite to real flows because factor services flows from households to firms are real flows and the factor payments made by firms to households are money flows.