Elementary Theory of Income Determination – Cash Flow of Income


The total income of a country is a reflection of real capital investment in that particular country. The volume of investment is determined mainly by certain factors. These factors include expectation of entrepreneurs, rate of interest, savings, marginal efficiency of capital, and consumption.

Cash flow of income

The circular flow of income refers to the flow of payments and receipts for factor services and for currently produced output passing between domestic firms and households. In other words, it describes the flow of payments from businesses to households in exchange for labor and other productive services and the return flow of payments from households to businesses in exchange for goods and services.

Some basic factors affecting circular flow are:

1. Savings: This constitute part of income which is not consumed immediately. They have the tendency to reduce the expenditure of the households and firms.

2. Injection: Injection of fund into the circle is an increase in the incomes of households and firms beside their normal processes of selling productive resources and manufactured goods.

3. Taxes: Taxes tend to reduce the volume of fund in circulation as it reduces the expenditure of firms and households.

4. Withdrawal: Withdrawal tends to reduce the amount of fund in circular flow of income.

5. Aids and grants: Aids and grants from government or other sources increase the volume of fund in the circular flow if income.

6. Import and export: While imports involve expenditure on foreign made goods and services leading to withdrawals from circular flow of income, exports provide funds leading to injection into the circular flow of income.

7. Investment: Investment creates an additional income leading to injection into the circular flow of income.

For a more comprehensive explanation, we can use a two-sector economy, which involves households and firms. The households supply factors of production (input) to firms which need them for production purposes. In return, they are paid wages, interest, rents and profits, which constitute their incomes. The members of the households use their incomes to purchase goods and services produced by the firms. This pattern of consumption expenditure made by households constitutes income for firms. This process leads to the formation of an income flow. The firms again use the income to purchase the productive services of households. Income, therefore, continues to flow in a circular manner to form the circular flow of income. While income flows in one direction, goods and services produced by the firm and the productive services of households flow in the other direction.