Income, circular flow of

Updated: Aug 20, 2021

Income, in the form of factor payments, is paid by firms to households which supply inputs. Households in turn spend part of their income on goods and services, this expenditure then accruing to firms as revenue and being again paid out by them to factors of production, and so on. It is this process of a flow of income from firms to households and a flow of expenditure from households to firms which is known as the circular flow of income. It is, in fact, a very simplified model of the working of the economy. Viewed in one way it shows the interrelationship between product and factor markets, with firms alternately in the roles of seilers and buyers and households alternately in the roles of buyers and seilers. Viewed in another way it is the basic prototype of the macroeconomic model of income determination, since it shows that national income will remain at the same leve! as long as households’ ‘withdrawals’ from the circular flow in the form of savings, taxation or expenditure on imports are counteracted by ‘injections’ into the flow such as government expenditure, investment expenditure, and export demand. If this is the case, the payments by firms to households, which become consumption, savings and taxes, will be equal to the receipts of firms, which consist of consumers’ expenditure, investment expenditure, government expenditure and exports, and so firms will have no reason to vary their production levels.

Reference: The Penguin Business Dictionary, 3rd edt.

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James Knight
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James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.