Explain the concept of circular flow of income.

Circular flow of income. Circular flow of income refers to continuous circular flow of money income and flow of goods among major sectors of an economy. Flow of money is the aggregate value of goods and services either as factor payments or as expenditure on goods and services. It is circular in nature because it moves in a circle coming back to the starting point. Again it is circular becuase it has neither any beginning nor an end. How? Suppose in an economy, there are two sectors, namely, Household sector and Firm sector. Households supply factor services and spend their income on consumption. The firms hire/purchase factor services from households and produce goods and services. The households as owners of factors of production (land, labour, capital and enterprise) receive the payments in terms of money as reward for rendering productive services. The recipients of these incomes (i.e., households), in turn, spend their incomes on purchase of goods and services (produced by firms) to satisfy their wants. Expenditure by households implies income going back to firms (producers of goods and services) making the circular flow of income complete. In short, income is first generated by production units, then distributed among households for rendering productive services and ultimately comes back to production units by way of expenditure by the households. In this way there is circular flow of income as depicted by outer arrows in Fig(a). (An economy has two types of markets — (i) Product market which is for goods and services, and (ii) Factor market which is for factors of production.)
Principles in circular flow of income. It involves two basic principles:
(i)    In an exchange process, the seller (producer) receives the same amount which the buyer (or consumer) spends.
(ii)    Goods and services flow in one direction and the money payments to acquire them flow in the return direction giving rise to a circular flow.