Circular Flow of Income: Meaning, Phases, Types and Significance

Macroeconomics tries to study the central questions of economies. Amongst these questions, the main question is how economies create wealth. In an economy, all factors of production (FoP) undergo a production flow/cycle; in the process of which, it generates wealth in the form of making payments to the factor of production, known as factor payments. Thus, the economic wealth of nations is created by generating this flow and producing commodities (goods and services), which are then consumed by consumers who spend their income on these goods and services.  

Circular Flow of Income

The circular flow of income is an economic model that reflects how money or income flows through the different sectors of the economy. A simple economy assumes that there exist only two sectors, i.e., Households and Firms. Households are consumers of goods and services and the owners of the factors of production (land labour, capital, and enterprise). However, the firm sector produces goods and services and sells them to households. 

In the circular flow of income (two-sector economy), there is an exchange of goods and services between the two players, i.e., the firms and households, which leads to a certain flow of money in the economy. Households provide the firms with the factors of production namely, Land (Natural Resources), Labor, Capital, and Enterprise that generates goods and services, and consumers spend their income on the consumption of these goods and services. The firms then make factor payments to households in the form of rent, wages, interest, and profit. This flow of goods and services and factors payments between firms and households reflects the circular flow of money in an economy. 

Phases of Circular Flow of Income

The three different phases in a circular flow of income are Generation, Distribution, and Disposition. 

1. Generation Phase

The first phase of the circular flow of income is Generation Phase. In this phase, the firms produce goods and services by taking the help of the factor services. 

2. Distribution Phase

The second phase of the circular flow of income is the Distribution Phase. In this phase, factor incomes such as wages, rent, interest, and profit flow from firms to the households.

3. Disposition Phase

The last phase of the circular flow of income is the Disposition Phase. In this phase, the income received by the factors of production is spent on the goods and services produced by the firms. 

Hence, through the different phases of the circular flow of income, the income generated in production units of an economy reaches back to the production units and completes the circular flow. 

Types of Circular Flow

The two types of circular flow are Real Flow and Money Flow. 

1. Real Flow

The flow of factor services from the households to the firms and the corresponding flow of goods from firms to the households in an economy is known as the Real Flow. Real flow is also known as Physical Flow. In this type of circular flow, there is no involvement of money and the goods and services are exchanged between the two sectors of the economy. This flow helps an economy in determining the magnitude of its growth process. For example, if more factor services are provided to the firms, then they will produce more volume of production, which will ultimately speed up the process of economic growth. 

The above diagram shows that the households provide factor services to the firm, and as a reward for their productive services, the firms provide the household with goods and services. 

2. Money Flow

The flow of factor payments from the firms to households for their factor services and the corresponding flow of consumption expenditure from households to the firms for the purchase of goods and services produced by the firms is known as Money Flow. Money flow is also known as Nominal Flow. This type of circular flow includes the exchange of money between the two sectors, i.e., households and firms. 

The above diagram shows that for the factor services provided by the households, firms make factor payments to them, and then households spend their income on the purchase of goods and services produced by these firms. 

Significance of Circular Flow of Income

1. Helps in understanding the mutual interdependence among different sectors

The different sectors of an economy involve the household sector, government sector, producer sector, and foreign sector. The circular flow of income of an economy helps in understanding the mutual interdependence between these sectors. In other words, it shows that these sectors of an economy are complementary to one another in a way that the economic activity of a country remains intact.

2. Helps in estimating National Income

The circular flow shows the three phases of income; viz., generation phase, distribution phase, and disposition phase. The income generated by an economy under these phases can be determined in three different ways, i.e., Production Method, Income Method, and Expenditure Method. 

3. Shows the equilibrium position of an economy

Any disturbance in the circular flow of an economy can result in disequilibrium putting an impact on its functioning. Therefore, the circular flow of income of an economy shows its equilibrium position. 

4. Helps in identifying different types of leakages and injections

The circular flow of income of an economy also helps it in the identification of leakages and injections in the economy. 

Leakages mean to withdraw money from the circular flow of an economy. Leakage from the circular flow of income of an economy happens when the firms and households save a part of their incomes. Therefore, leakage or withdrawal is that part of the income of an economy that does not pass through the circular flow of income, resulting in the unavailability of that money for spending on the goods and services produced recently. Thus, it can be said that leakages reduce the flow of income in an economy. 

Injections mean the addition or introduction of income to the circular flow of an economy. Injections into the circular flow of income are a result of money borrowed by households and firms from different external sources, like financial institutions. However, this additional income does not result in an immediate expenditure. Therefore, injections increase the flow of income in an economy.