Circular Flow of Income

Lesson

Part 1 — production, income and spending moving in a circle between households and firms.

In this lesson you will

Explain the circular flow of income and why it never stops
Draw the two-sector model with its real and money flows in the factor and product markets
Show how saving and investment through the financial market keep the flow steady

Part 1 at a glance

Concept

What is the circular flow of income?

Firms produce, production creates income for the owners of factors, income is spent on output, and spending lets firms produce again.

Production, income, spending

Concept

We begin with the simplest possible economy and add features one at a time.

Table of the assumptions of the simple two-sector model: only households and firms, all income spent, all output sold to households, and households own all the factors
Assumption of the simple model	What it rules out
Only households and firms	No government, no foreign trade
Households spend all their income	No saving
Firms sell all output to households	No unsold stocks, no investment
Households own all the factors	Firms pay all output value as factor incomes