Circular Flow of National Income

Circular Flow of National Income : 

Circular flow of income is the basic concept in macro economics. The circular flow of income refers to the process whereby an economy's money receipts and payments flow in a circular manner continuously through time.

• The circular flow model demonstrates how money moves from producers to households and back again in an endless loop.
• In an economy, money moves from producers to workers as wages and then back from workers to producers as workers spend money on products and services.
• The models can be made more complex to include additions to the money supply, like exports, and leakages from the money supply, like imports.
• When all of these factors are totaled, the result is a nation's gross domestic product (GDP) or the national income.
• Analyzing the circular flow model and its current impact on GDP can help governments and central banks adjust monetary and fiscal policy to improve an economy.

Circular flow of income can be determined for the following : 
1) Two sector Economy (Households and Business Firms.) Y = C + I 
2) Three sector Economy (Households, Business Firms and Government sector)  Y = C + I + G 
3) Four Sector Economy (Households, Business Firms, Government and Foreign sector) Y = C + I + G + (X-M)

Two sector model of Circular flow of National Income :
There are two sectors, households and firms. It divides the diagram into two parts. The upper half represents the factor market and the lower half represents the commodity market.
Figure below explaines circular flow of income and expenditure in a two sector model.

In the above figure, the factors of production flow from the households to the firms. The firms use these factors to produce goods and services required by the households. Thus, goods flow from the households to the firms and from the firms back to the households. It is called product flows. 
In the same way, money flows from the firms to the households in the form of factor payments such as rent, wages, interest and profit. Households use this income to purchase goods and services. Thus, money flows from the firms to the households and from the households back to the firms. It is called money flows.
In the circular flow of income, production generates factor income, which is converted into expenditure. This flow of income continues as production is a continuous activity due to never ending human wants. It makes the flow of income circular.

You need to know:

I) Three Sector Model of Circular Flow of National Income :
Under a three sector model, the  government sector is added to the existing two sectors i.e. households and business firms. 
II) Four Sector Model of Circular Income:
In an four sector model, foreign sector is added to the existing three sectors i.e. households, business firms and government sector.