The Circular Flow of Income - SS3 Economics Lesson Note

The circular flow of income is a basic economic concept that explains how money flows through the economy. It shows how households and businesses interact with each other in the market, and how they exchange goods and services for money. The flow refers to the movement of money from demand to supply, and prices, and back into people's pockets as income.

This continuous cycle of income, expenditure, and production creates a stable economy, where both households and businesses can benefit from each other. From the diagram, below, we are presented with a model of a two-sector economy comprising the sectors: of households and business firms. The red arrows represent the flow of goods, services and factors of production, while the blue arrows represent the flow of payment for goods and factors of production supplied between both sectors respectively.

The circular flow of income starts with households, which are the owners of factors of production which are labour, land, and capital. Households include all individuals and family units of the economy. These households supply these resources i.e. factors of production, to businesses in exchange for wages, rent, and interest i.e. the rewards for factors of production.

Business firms are engaged in the buying and hiring of resources to produce and sell goods and services. They include some proprietorships, partnerships, and companies at all levels of the productive subset of the economy. The businesses use these resources obtained from the households to produce goods and services, which they sell to households in exchange for money.

The money that households pay to businesses for goods and services becomes the businesses' revenue. This revenue is then used to pay for the resources they used to produce the goods and services. Such payments are in the form of wages/ salaries, rent, and interest.

The circular flow of income continues as businesses use the remaining revenue to invest in their business or pay dividends to their owners. Dividends are payments made to individuals or groups that own 'shares' of the business. While the continued investments back into the business create jobs and income for households, which can then use that income to buy more goods and services.