The Two-Sector Circular Flow
Idea
The two-sector model of the circular flow of income strips the economy to its two essential agents — households and firms — and shows income circulating between them as two opposing flows.
Mechanism
Households play two roles. As resource owners, they supply factors of production — land, labour, capital and entrepreneurship — to firms, and receive factor income in return: rent, wages, interest and profit respectively. As consumers, they spend that income on the goods and services firms produce, and this consumer expenditure becomes firms’ revenue.
This gives two flows running in opposite directions:
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a real flow — factor services from households to firms, and goods and services from firms to households;
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a money flow — factor income from firms to households, and consumer expenditure from households to firms.
Expenditure thus creates income: spending by households becomes revenue for firms, which is returned to households as payment for factor inputs, which is spent again. At equilibrium the loop balances, so national income = national expenditure.