The circular flow of income and expenditure refers to the process whereby the national income and expenditure of an economy flow in a circular manner continuously through time. The various components of national income and expenditure such as saving, investment, taxation, government expenditure, exports, imports, etc are shown on diagrams in the form of currents and cross-currents in such a manner that national income equals national expenditure.
We begin with a simple hypothetical economy where there are only two sectors, the household and business. The household sector owns all the factors of production, that is, land, labour and capital. This sector receives income by selling the services of these factors to the business sector. The business sector consists of producers who produce products and sell them to the household sector or consumers. Thus the household sector buys the output of products of the business sector. The circular flow of income and expenditure in such an economy is shown in Figure 5.1 where the product market is shown in the upper portion and the factor market in the lower portion.
In the product market, the household sector purchases goods and services from the business sector while in the factor market the household sector receives income from the former for providing services. Thus the household sector purchase all goods and services provided by the business sector and makes payments to the latter in lieu of these.
The business sector, in turn, makes payments to the households for the services rendered by the latter to the business
→ wage payments for labour services,
→profit for capital supplied, etc
Thus payments go around in a circular manner from the business sector to the household sector, and from the household sector to the business sector, as shown by arrows in the outer portion of the figure.
There are also flows of goods and services in...