1.1 INTRODUCTION, 1.2: MEANING OF CIRCULAR FLOW, 1.3: CIRCULAR FLOW IN A TWO SECTOR ECONOMY (SIMPLE ECONOMY), 1.4: TYPES OF CIRCULAR FLOW, 1.5: STOCK AND FLOW
1.1: INTRODUCTION: Every country in the world have a maximum number of 4 sectors in its economy. Those are:
- Firm,
- Households,
- Government, and
- Foreign Sector.
But in our syllabus, we have to study the flow of income between firms and households.
Firms pay money to the householders in the form of a salary, wages, profit sharing, and other forms. after receiving money householders purchase some products from firms. In this process Money firstly generated from firms then distributed among householders then again this money from householders comes a return to firms.
Such a flow of money in the form of income between householders and firms is known as a circular flow of money/Income.
Note: Some important terms which you must know:
- Households: These are the persons who provide factor services to firms and consume final goods/products & services.
- Firms: These are the units that produce final goods and services and sell to households and in return to receive money.
- Factor Services: These are the services provided by households to firms. With these factor services, firms produce goods. These are 4:
-
- Land: For work firms require land, this is acquired by firms from households.
- Labor: For production or provide service, firms hire laborers or employees within households.
- Capital: It’s the money that is received by the firm from householders by offering shares, stocks, or other activity.
- Entrepreneurship: It’s kind of risk taken by the household to open a firm and to achieve profit.
- Factor Payments: This is the amount paid by firms to households in return of factor services. These are Salary, Rent, Profit, Interest, etc.
- Consumption Expenditure: This is the amount paid by households to firms when they purchase goods or services.
1.2: MEANING OF CIRCULAR FLOW OF INCOME: It refers to the cycle of the flow of income between different sectors of the economy. If we talk about the two-sector economy with householders and firms. In this kind of economy, the circulation flow of income refers to the cycle of income between households and firms in different phases.
1.2.1: Phases of Circulation flow of Income: There are three phases.
- Generation/Production Phase: By using Factor Services, Firms produce goods and services.
- Distribution Phase: In this phase, Firms do factor payments to households in the form of Salary, Rent, Profit, Interest, etc.
- Disposition Phase: In this phase, households spend their income to purchase goods and services from firms.
1.3: CIRCULAR FLOW IN TWO SECTOR ECONOMY: A two-sector economy means a simple economy in which we study the income flow in between two sectors of the economy, named as households, and firms.
Assumptions:
- We neglect the other two sectors, named Government & Foreign. So it’s like a closed economy.
- Households provide Factor services(Land, Labour, Capital, Enterprise) to firms only and firms receive factor services from households only.
- Firms pay factor payments (Rent, Salary, Profit, Interest) to households only and households receive income from firms only.
- Households spend their entire income to purchase goods and services produced by firms. and firms sell entire products to households only.
- Neither firms nor households save money in the economy.
1.4: TYPES OF CIRCULAR FLOW: These are two types:
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