Modern economy is a money economy. Money is used in the process of exchange and it has removed the difficulties of barter system. As we know money acts as a medium of exchange.
In an economy, households supply factors to the firms (producing units). Finns pay for the use of factors. So households receive payments from firms for their services in terms of money.
So in money economy there is a flow of productive resources or factors and there is a flow of money corresponding to the flow of economic resources (or factors) and flow of goods and services produced by economic resources.
Circular Flow of Income in a Two Sector Economy:
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As we know resources like land, labour, capital and entrepreneurial ability flow from households to firms, the producing units. Money flows from firms to the households as factor payments in the form of wages, rent, interest, profits. Again income received by households in money terms from the firms again flow from households to firms as consumption expenditure made by the households.
The circular process begins with the flow of economic resources from household to firms to produce and flow of money to households in the form of factor income and again money flows from households to firms as consumption expenditure made by the households.
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From Fig. 2, it is clear that labour, land, capital and entrepreneurial ability flow from households to firms (as indicated by arrow mark). In opposite direction to this, money flows from firms to households as factor payments such as wages, rent, interest and profits.
In the lower part of the figure, money flows from households to firms as consumption expenditure made by the households on the goods and services produced by the firms while the flow of goods and services is in opposite direction from firms to households. We saw that money flows from firms to households as factor payments and then again it flows from households to firm.
So there is a circular flow of income in between two sectors – household sector and firm sector. This circular flow of money will continue indefinitely. In this way the economy functions. But, it is a fact that this flow of money income will not always be same.
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The volume of flow changes. During depression, this volume of flow of money will contract and less and in prosperity it will expand with changes in national income. This circular flow of money is a measure of national income. The flow of money changes with the change of national income. Assumptions of circular flow of income analysis:
Neither the households from their incomes nor the firms from their profits save.
Government does not play any part in the national economy.
There is no export and import of goods and services by the economy. It means we have assumed a closed economy.
Thus, in this analysis we have not taken into account the role of foreign trade, domestic savings and the role of government.