Circular Flow

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In economics, the term circular flow of income refers to an economic model, which illustrates the circulation of income between producers and consumers. In the circular flow model, the terms producers and consumers are referred as “firms” and “households” respectively, where both provide each other with factors in order to facilitate the flow of income. Firstly, the households own the factors of production (inputs to production). Households rent labor to firms in exchange for wages. Households are also the ultimate owners of firms and obtain their profits. Households ultimately own the capital and land even if firms hold them. Firms instead provide households with goods and services in exchange for household’s expenditure (wage) and also “factors of production” from households. In this process, household sector provides various factors of production such as land, labor, capital and enterprise to producers who produce by goods and services by coordinating them. Producers or business sector in return makes payments in the form of rent, wages, interest and profits to the household sector. Again household sector spends this income to fulfill its wants in the form of consumption expenditure. Business sector supplies them goods and services produced and gets income in return of it. Thus expenditure of one sector becomes the income of the other and supply of goods and services by one section of the community becomes demand for the other. This process is unending and forms the circular flow of income, expenditure and production. The figure shows the circular flow between households and firms. The inner loop represents the flow of real resources. Households supply the services of factors of production to firms who use these factors to produce goods and services for households. This is known as the “Real Flow”. The outer loop instead represents the corresponding flow of payments. Firms pay factor incomes to households but receive revenue from household’s spending on goods...
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