Circular Flow of Income

In the previous article, “Circular flow of products” we saw how products flow in the economy. Firms buy factors of production from households in the factor market and sell finished goods back to them in the finished goods market.

When firms buy factors of production (land, capital and labor) from the factor market, they need to reimburse households for the same. Thus, in factor market money is flowing from firms to households. Money spent by firms is their cost of production and earnings for the households. In the finished goods markets, firms are selling their products to households, so money is flowing from households to firms. As shown in the diagram below money and products flow in opposite directions, money moves clockwise and products flow anti clockwise. The cumulative amount spent by households is equal to the revenue of the firms. The difference between the amount earned by firms in the finished goods market and the money spent by firms in the factor market is the firm’s profit.

The diagram also makes it obvious that expenditure of one entity is equal to total income of another; applying the same working to the entire economy, total expenditure in the economy is always equal to the total income.

Let’s talk a little more about the income received by households. In the factor market, households earn various kinds of income from firms. Income received for renting out land is termed rent. In return for labor provided by household’s, they receive salary/wages and capital earns interest. It is easy to understand how land would earn rent and labor would earn wages/salary, but understanding how capital earns interest is a little difficult.

Let’s now see how capital, which we earlier defined as machinery, tools and technology earns interest for households.