Question

Explain the Circular Flow of Income in two Sector Economy with the help of diagram.

Hint:

In a two-sector model, we assume all income is spent. If savings are introduced, they are considered a "leakage," while investments are "injections."

Answer 1

Step 1: Understanding the Concept:
The circular flow of income is a model representing the flow of payments for factors and payments for goods between different sectors of the economy. In a simple two-sector model, we ignore the government and foreign sectors.
Step 2: Detailed Explanation:
There are two types of flows between Households and Firms:
1. Real Flow: Households provide factor services (Land, Labor, Capital, Enterprise) to Firms. In return, Firms produce goods and services and sell them to Households.
2. Money Flow: Firms make factor payments (Rent, Wages, Interest, Profit) to Households for their services. Households then use this money for consumption expenditure to buy goods from Firms.
The Diagrammatic Path:
- Upper Loop: Money flows from Firms to Households as income.
- Lower Loop: Money flows from Households to Firms as payment for goods.
In this closed system, Total Production = Total Income = Total Expenditure.
Step 3: Final Answer:
The model illustrates that in an economy, the expenditure of one person is the income of another, creating a never-ending circle of economic activity.