CBSE Class 12 Economics - Circular Flow of Income

Meaning of Circular Flow Of Income:

It refers to the cycle of generation of income in the production process, its distribution among the factor of production and finally, its circulation from households to firms in the form of consumption expenditure on goods and services produced by them.

Phase in Circular Flow of Income

In the First Phase(Production Phase), the firm produces goods using factors of production(Land, Labor, capital and Enterprise)
In the Second Phase (Income Phase), the firms make factor payments (Rent, wages, Interest & Profit) to the household for providing factor services.
In Third Phase (Expenditure Phase), the households spend the amount received by firms in purchasing their products.

Stock and Flow

Stock Variables- It refers to those variables, which are measured at a particular point of time, for example- Government Budget, National Capital, etc.
Flow Variable- It refers to those variables, which are measured over a period of time, for example-National Income, any transactions in money, etc.

Difference between Stock and Flow
BASIS	STOCK	FLOW
Meaning	Stock variables refer to those variables, which are measured at a particular point of time.	Flow variables are those variables which are measured over a period of time.
Time Dimension	It does not have a time dimension.	It has a time dimension as it is measured over a period of time.
Nature of concept	It is a Static Concept	It is a dynamic Concept
Examples	The population of any country, capital, stock of machines, etc.	Savings, depreciation, Interest rate etc.

TYPES OF CIRCULAR FLOW

Different types of circular flow are- Real Flow and Money Flow.

Real Flow - It refers to the flow of factor services (land, labor, capital, and enterprises) from household to firms and the flow of goods and services from firms to households. It is also known as ‘Physical Flow’.

Money Flow - It refers to the flow of factor payments (Rent, wages, interest, and profit) from firms to households for providing factor services and flow of consumption expenditure from households to firm for providing goods and services. It is also known as Nominal flow.

Difference between Real Flow and Money Flow
BASIS	REAL FLOW	MONEY FLOW
Meaning	It is the flow of goods and services between households and firms.	It is the flow of money between firms and households.
Kind of Exchange	It involves the exchange of goods and services.	It involves the exchange of money.
Difficulty in Exchange	These may be the difficulty of the Barter system in exchange of goods & factor services.	There is no such difficulty in the case of money flow.
Alternate Name	It is also known as 'Physical Flow'	It is also known as 'Nominal Flow'

Circular Flow in Two Sector Economy

In a simple two-sector economy, there exist only 2 sectors i.e. household and firms, where households provide factors of production (Land, Labour, Capital, and Enterprise) and consumer goods & services made by the firm and sell them to households.

In order to make our analysis simple, we can make some assumptions:-

Only two sectors in an economy are there i.e. Households and firms.
Households provide factor services to firms only and firms hire factor services from household only.
The amount received by the household from the firm for providing factor services is used entirely on consumption.

This brings us to the following conclusion.

There are no savings in the economy, i.e. neither the household saves from their incomes, not the firm saves from their profits.
In the given diagram, it can be seen that households are providing factor services in exchange for factor payment and firms are providing goods & services to households in exchange for consumption expenditure.
Total Production = Total Consumption
Factor Payment = Factor Income
Consumption Expenditure = Factor Income
Real Flow = Money Flow

Circular Flow in Two Sector Economy With Financial Markets

Circular Flow of Income in 2 Sector Economy assumes that there is no savings i.e. households spends their entire income on consumption of goods and firms spends all their receipts in making factor payments.

But in real-world, this does not happen i.e. household saves some part of their factor incomes for future contingencies, whereas firms save some parts of their profits for expansion or some other reasons.

The firm also borrows money from Financial Institutions for the same. All savings and borrowings are channelized through Financial Institutions / Market.

Financial Markets refers to institutions such as banks, insurance companies, etc. which transacts in loanable funds. Savings of households accumulated in the financial market are utilized by firms for investments purposes.

Leakages

Leakages refer to the withdrawal of money from the circular flow. Leakages reduce, the flow of income.

Examples of leakages in different types of Economics:-

(1) Two sector Economy (without- No leakages financial market)

(2) Two sector Economy (with financial –saving s market)

(3) Three Sector Economy-Savings + Taxes (Government)

(4) Four Sector Economy-Savings + Taxes + Imports

Injections

Injections refer to the introduction of income into the circular flow. Injections increase the flow of Income.

Examples of Injections in different types of economies:

Two Sector Economy(without – no injections financial market)
Two Sector economy(with the financial-investment market)
Three Sector Economy-Investment + government expenditure
Four Sector Economy-Investment + government + exports

Equilibrium is achieved when leakages are equal to injections.