Circular flow of income is a neoclassical model which tells us how income or money circulates in an economy. Circular flow of income means that income and expenditure in an economy are related to each other in a circular way.
Receiving of income and production of goods are two faces of one economic activity. An individual will receive income only if goods and services are produced in market. An individual works and gets income and he spend that income to buy goods and services to fulfill his desires or in order to get utility. By, this we mean that there is a direct relation between production of goods or services and income spending.
Circular-flow diagram presents a visual model of the economy.
Circular flow of income model has two types of decision makers:
- Firms basically represents the production side of of the economy, while households represents the consumption side of the economy.
- Firms employ various factors of production , who produces all kinds of goods and services which are demanded by the rational people. Firms sell their outputs in market and receive payments in form of money. Now the money received by the firm is distributed among those employed factors (labors) in form of wages, profits,rents etc.
- On the other side the households performs two functions. Firstly, they provide their services to firms as labors and receives income. Secondly, the households becomes consumers and buyers of those outputs produced in market and spend their income on the purchase of goods and services.
- The process of production of goods and services is also the process of generating incomes which leads to spending and consumption. The fact that they are inter-related.
- By this all we mean that production creates income which leads to spending which in turn calls for further production. Thus the economic activity continues in a circle.