Production, consumption and investment are important economic activities of an economy. In carrying out these economic activities, people make transactions between different sectors of the economy. Because of these transactions, income and expenditure move in circular form. This is called circular flow of income. It is based on two principles:

  1. The expenditure of the buyer because the income of the sellers.
  2. Good and services flow in one direction from sellers to buyers while money payment for these goods, and services flow in opposite direction i.e. from buyers to sellers.

In this way, the flow of goods and services (real flow) and flow of money payments (money flow) together make a circular flow.

 

Real Flow

Households render factor services as owners of land, labour, capital and entrepreneurship to firms. The firms produce good, and services to meet the demand of the households. Such flow of factor services from households to firms and flow of goods and services from firms to households is know as real flow.

Money Flow

In modern economies, goods and services and factor services are valued is terms of money. Households receive rent for land, wages for labour, interest for capital and profit for entrepreneurship from firms and make payment for goods and services supplies by firms. This flow of money between firms and households is called money flow.

An open economy can by divided into following five sectors:

  1. Producing sector
  2. Household sector
  3. Government sector
  4. Financial sector
  5. Rest of the world sector