Circular Flow Model Of A Market Economy

In the basic two-sector circular flow of income model, the economy consists of two sectors: (1) households and (2) firms. (Some sources refer to households as “individuals” or the “public” and to firms as “businesses” or the “productive sector. ” ) The model assumes that there is no financial sector, no government sector, and no foreign sector. In addition, the model assumes that (a) through their expenditures, households spend all of their income on goods and services or consumption and (b) through their expenditures, households purchase all output produced by firms. This means that all household expenditures become income for firms. The firms then spend this all of this income on factors of production such as labor, capital and raw materials, “transferring” all of their income to the factor owners (which are households). The factor owners (households), in turn, spend all of their income on goods, which leads to a circular flow of income.

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