Circular flow of income in a two-sector economy
Assume only two sectors: households and firms. No government, no foreign trade, households spend all their income, firms sell all output to households.
- Real flow: households supply factor services (land, labour, capital, enterprise) to firms; firms supply goods and services to households.
- Money flow: firms pay factor payments (rent, wages, interest, profit) to households; households pay for goods and services (consumption spending) to firms.
The two flows run in opposite directions. Since one person's spending is another's income, the money keeps going round: the circular flow of income.
Leakages and injections (for a fuller picture)
If households save part of income, that is a leakage. If firms borrow savings to invest, that is an injection. The flow stays steady only when leakages equal injections (S = I).
Why three methods give the same answer
The circle can be measured at three points in a year:
- At the firms: value of goods produced (net of inputs) → product / value added method.
- Where money reaches households: factor incomes → income method.
- Where households and others spend: final spending → expenditure method.
Every rupee of value produced is paid to someone as income and is bought by someone. So Product = Income = Expenditure.
Value added (product) method
Value added of a firm = value of output − intermediate consumption. Value of output = sales + change in stock.
Farmer: output 50, inputs 0 → VA 50. Miller: 80 − 50 = 30. Baker: 100 − 80 = 20. GVA = 100.
Steps: (1) classify producers into primary, secondary and tertiary sectors; (2) find gross value added (GVAmp) of each; (3) add them to get GDPmp; (4) subtract depreciation and net indirect taxes, add NFIA to reach national income.
Precautions
- Do not count intermediate goods (avoid double counting).
- Do not count sale of second-hand goods (only the dealer's commission is new value).
- Count production for self-use (farmer keeping grain), and imputed rent of owner-occupied houses.
- Do not count unpaid household services (a mother cooking at home) because they are hard to value.
Income method
Add all factor incomes produced inside the country:
- Compensation of employees: wages, salaries, bonus, employer's contribution to social security.
- Operating surplus: rent + royalty + interest + profit (dividends, corporate tax, retained profit).
- Mixed income of the self-employed (a shopkeeper who uses his own labour and capital).
Sum = domestic income (NDPfc). Add NFIA to get national income (NNPfc).
Precautions
- Do not include transfer payments (scholarships, old-age pension, gifts): no service is given in return.
- Do not include windfall gains (lottery) or capital gains on selling old assets.
- Interest on loans for consumption and on government debt is usually treated as a transfer, not factor income.
Expenditure method
Add final spending on goods and services produced inside the country:
GDPmp = C + I + G + (X − M)
- C = private final consumption expenditure (households).
- I = gross domestic capital formation (fixed investment + change in stock).
- G = government final consumption expenditure.
- X − M = net exports.
Precautions
- Do not include spending on intermediate goods.
- Do not include transfer payments by government.
- Do not include buying shares, bonds or second-hand goods (financial or old assets, not new output).
Key formulas and definitions
- Value added = Value of output − Intermediate consumption
- Value of output = Sales + Change in stock
- NDPfc (income method) = Compensation of employees + Operating surplus + Mixed income
- GDPmp (expenditure method) = C + I + G + (X − M)
- National income (NNPfc) = NDPfc + NFIA
Worked examples
1. A farmer sells wheat worth ₹60 to a miller. The miller sells flour worth ₹90 to a baker. The baker sells bread worth ₹130 to families. Find value added by each and GDP.
Farmer 60 − 0 = 60; miller 90 − 60 = 30; baker 130 − 90 = 40. GDP = 60 + 30 + 40 = 130 = value of final bread.
2. A firm's sales are ₹500, opening stock ₹40, closing stock ₹70, raw materials bought ₹200. Find value of output and gross value added.
Change in stock = 70 − 40 = 30. Value of output = 500 + 30 = 530. GVA = 530 − 200 = ₹330.
3. Compensation of employees 400, rent 60, interest 50, profit 120, mixed income 170, NFIA −10. Find domestic income and national income.
Domestic income (NDPfc) = 400 + 60 + 50 + 120 + 170 = 800. National income = 800 + (−10) = 790.
4. Private consumption 700, government consumption 150, gross investment 200, exports 60, imports 90. Find GDPmp.
GDPmp = 700 + 200 + 150 + (60 − 90) = 1020.
5. Which of these are included in national income? (a) old-age pension, (b) rent of a self-owned house, (c) commission of a used-car dealer, (d) purchase of shares.
(b) yes, imputed rent is a service; (c) yes, the dealer's service is new. (a) no, a transfer payment; (d) no, a financial asset.
6. In a two-sector economy households earn ₹1000 and spend ₹800. Firms invest ₹200. Is the flow steady?
Saving = 1000 − 800 = 200 = investment. Leakage = injection, so the circular flow is steady at ₹1000.
Common mistakes
- Adding total sales of all firms instead of value added. That is double counting.
- Including transfer payments (pension, scholarship) in the income method. No productive service was given.
- Forgetting the change in stock when finding value of output.
- Counting purchase of second-hand goods in the expenditure method. They were counted in the year they were made.