Circular Flow of National Income

The movement of national income from households to firms and from firms to households in a circular manner during a specific time period in an economy is called circular flow of national income

Framework or National Income Circular Flow Diagram

It can be explained with the help of following diagram.

diagram of national income circular flow

This diagram shows that households provide services of factors of production to the firms, firms produce goods and services with the help of these factors of production.

Final goods and services are sold to households at a particular price.

The product of prices and quantities of output represents market value (i.e. MV=P.Q).

The summation of the market value of all final goods and services produced by an economy during a year constitutes national income (shown in the upper part of the figure).

This income transfers from households to firms.

The lower portion represents calculation of national income on the basis of total expenditures approach. Firms make the payments in the form of rent, wages, interest and profit to landlords, labour, capital owners and entrepreneurs respectively.

The summation of these rewards also constitutes national income shown in lower part. The households spend their income on the purchases of final goods and services from the firms.

The upper portion of the diagram represents national income on the basis of market price. The lower portion represents national income on the basis of factors price or total expenditure method.

In both portions, we observe that national income moves from households to firms and from firms to households in a circular manner.

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