Economics » National Income » The Circular Flow of Income (Two and Three-Sector Models)

The Circular Flow of Income

The Circular Flow of Income

Fig. 11.1: The Circular Flow of Income

The diagram (Fig 11.1) shows Real Flow (goods and services) and monetary flow (income and expenditure). The bottom pair of arrows depict the goods market. In this market, households exchange money for the goods and services produced by the firms. The total value of these goods and services estimates national income from the product/output side. The other arrow shows the expenditure approach. (The summation of these expenditures represents the expenditure approach). The top pair arrows represent the factor market in which the firms exchange money for the services provided by the households, that is, wages – payments for labour services, interest for capital, rent for land and profit for entrepreneurship. This look at national income represents the incomes earned by factors of production for producing the economy’s goods and services. The circular flow diagram shows that national income may be measured by final output or product (Product or Output Method), final incomes (Income Method) and final expenditure (Expenditure Method). The diagram gives us the basic national income identity:

National Income = National Product = National Expenditure.

This identity means that actual incomes received in the economy are identical to both actual expenditure and actual output or product produced in the economy. We must also emphasize here that in accounting for national income, we use ex-post (what actually happened in the economy) not ex-ante (what people wish or intend to happen).

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