Answer:
The circular flow of income is an economic model, which depicts exchanges between different agents in an economy as flows of money, services etc. It basically demonstrates how money/factor services moves from producers to consumers and back again in an endless loop.
Phases of circular flow of income:
Production phase: Firms produce goods and services with the help of factor services i.e. land, labour, capital and entrepreneurship.
Income phase: It involves the flow of factor income (rent, wages, interest, profit) from firms to households.
Expenditure phase: The income received by the factors of production is spent on goods and services produced by firms.
Circular flow of income in a simple economy:
In a simple economy, the underlying assumption is that there are only two sectors in the economy i.e. ‘households’ and ‘firms’ and there is no government, external trade or any savings by the households. Thus all other channels of household expenditure i.e. taxes or import of goods are closed. Consequently, they can only spend their income on the goods and services produced by the
domestic firms, which they themselves assisted in producing. Thus, aggregate consumption by the households equals the aggregate expenditure on goods and services produced by the firms in the economy. The entire income of the economy, thus, comes back to the producers/firms in the form of sales revenue and there is no leakage.
In the next period, the firms will again produce goods and services and pay remunerations to the factors of production i.e. households, which will once again be used to buy the goods and services.
Hence, every year, the aggregate income of the economy goes through the two sectors i.e. firms and households, in a circular way.
However, the above illustration is a simplified model, which does not describe the actual economy in detail. For instance, in an actual economy, households save, the government is involved, there is international trade etc
