The circular flow of income

Imagine a simple economy (a model) with only households and firms: no government, no foreign trade, and no saving.

• Households supply the factors of production to firms: labour, capital, land and entrepreneurship.
• Firms pay them in return: wages, interest, rent and profit.
• Households spend all this income buying the goods that firms produce, and that spending becomes the firms' revenue again.

So money goes round and round: spending becomes income, and income becomes spending. This is the circular flow of income.

National income can be measured at three points on the circle:

• at A, where households spend: the expenditure method;
• at B, where firms produce: the product (value added) method;
• at C, where firms pay the factors: the income method.

All three give the same value, however complicated the economy.

A surprising result: if everyone in the economy spends ₹10 more, firms produce ₹10 more and pay ₹10 more to the factors, so total income also rises by ₹10. One household cannot raise its income just by spending more, but the economy as a whole can. The whole behaves differently from its parts.