Sectors of the Economy:

1. Household Sector: It includes consumers

of goods and services. Households are also the
owners of the factors of production

2.Producer sector/Firms: It includes all the

production Units(firms) in the economy. For
the production of goods and services, the
firms hire / purchase factors of production
(L, La, K, O) from the households.
3.Government Sector:
It includes (i) Government as a welfare
agency (ii) Government as a producer.

4.The External sector (ROW):

It includes all such activities which are
related to export and import of goods and
services, and the floe of capital between the
domestic economy and the ROW.
 Circular Flow Of Income

• Macro economics focuses on understanding and assessing the

overall performance of an economy .

• Production of goods and services, Generation of Income and

Expenditure OR Disposition are the three basic parameters that
indicate the level of economic activity in an economy .

• Circular flow of Income refers to the continuous flow of the

activities of production, Income generation and expenditure
involving different sectors of the economy. Each activity is the
cause as well as the consequence of the other activity.
• Behavior of these parameters is analyzed through
circular flow of money (and product) across
four sectors of an economy , households , producers ,
government and rest of the world .

• By studying interdependence among these sectors (in

terms of the flow of money or product), we come to
know what is the level of production , the level of
income and the level of expenditure in an economy.
Together the level of these macro variables indicate the
overall level of economic activity in the economy
 Circular flow of National Income:
It is a pictorial illustration of interdependency between the major sectors of
economic activities. It explains the circularity of interdependence like
households getting final goods from the producers and producers getting
factor services from the households.

Two -Sector Economy:

Factor Services (land ,labor, k ,o) Factor Market

Factor payment (W,R,I,P)

Household
Firm

Goods and Service

Payment for Goods & services

Product Market
 Real Flow : - Real flow of income implies the flow of factor services from the household sector to the
producing and the corresponding flow of goods and services from the producing sector to the household sector.

Factor Services (land ,labor, k ,o)

Producing Sector Household Sector

Goods and Services

 Money Flow : - Money flow of income implies the flow of factor incomes-rent, wages, interest and profit from the
producing sector to the household sector and the corresponding flow of expenditure /payments on the goods and
services

Payment for Goods & services

Producing Sector Household Sector

Factor payment (W,R,I,P)

 Why is the Flow of Income and Product is called the circular flow?

• It is because of the following reasons:-

• Corresponding to each real flow to one direction , there
is a money flow from the opposite direction .
• Receipts of one sector from other sectors are equal to
the payments to other sectors.
(i) Factor payments by firms = Value addition by the firms. Thus, value
addition is converted into factor incomes .
(ii) Total production of goods and services by firms = Total
expenditure on goods and services by the household sector. Thus,
all income is converted into expenditure on goods and services.
(iii) Value addition ≡ Income generated ≡ Expenditure on goods and
services.
Hence, the triple identity.
Money flows are just the monetary expression
of real flows. Briefly, one can observe from the
Circular Flow Model that: value added is
converted into income and income is converted
into expenditure. It is this conversion process
which keeps the circular flow always in a state
of circularity.
This Model offers the following observations :-

Injections

Factor Services (land ,labor, k ,o)

Factor payment (W,R,I,P)

Household
Firm Financial system
Goods and Service

Payment for Goods &

services
Lekages