Circular Flow of Income (Basic)
Two-sector circular flow model showing the flow of income and expenditure between households and firms through goods markets and factor markets.
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The two-sector circular flow of income shows how households and firms are linked through two markets. In the factor market, households supply land, labour, capital and enterprise to firms, and firms pay them factor incomes: rent, wages, interest and profit. In the goods and services market, firms sell their output to households, and household spending becomes the firms' revenue. Because all income is spent and all spending becomes income again, the value of total spending, total output and total income is the same, which is why national income can be measured in any of these three ways.
Key points
- There are two sectors, households and firms, and two markets: the goods and services market and the factor market.
- The inner loop is the real flow: factors of production go from households to firms, and goods and services go from firms to households.
- The outer loop is the money flow: consumer spending goes from households to firms as revenue, and factor payments go from firms to households as income (rent, wages, interest and profit).
- In each market the money flow runs in the opposite direction to the real flow it pays for.
- In this closed two-sector model, total spending = total output = total income; the extended model, Circular Flow of Income — Injections and Withdrawals, adds saving, taxes, imports, investment, government spending and exports.
Exam tip
Follow each loop with your finger before you explain it. On the inner (real) loop, factors of production go from households through the factor market to firms, and goods and services go from firms through the goods and services market to households. On the outer (money) loop, every flow runs the other way, so each real flow is matched by a payment travelling in the opposite direction through the same market.
Common mistakes
Students often draw money and real flows going the same way, for example showing money going from households to firms in the factor market, when it is factor services that go that way and the payment for them goes back to households. Another slip is mixing up the two markets: income is paid through the factor market, while consumer spending passes through the goods and services market.
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