In everyday life we experience the circular flow of income between households and firms. If we buy an item in the shop we are doing the circular flow between households and firms. It is important to us to know how the circular flow works. We can control our spending and can save as much as we can if we fully understand the circular flow. In macroeconomics it stated there that the terms circular flow refers to a straightforward economic form which portrays the mutual circulation of income between manufacturer and patrons. In the circular flow model, the mutually supporting entities of manufacturer and buyer are referred to as “firms” and “households” correspondingly and supply each other with aspects in order to ease the flow of income. The households are the one who owns the factors of production (FOP) while the firms are the one who uses the factors of production such as land, labour, entrepreneurship and capital. By the factors of production the firms will pay the factors of income to the households. Such as in land the firm will pay rent, in labour the firm will pay wages, in entrepreneurship the firm will pay profits and in capital the firm will pay interest.

1.1 BODY:

1.1.1 CIRCULAR FLOW BETWEEN HOUSEHOLDS AND FIRMS:

The diagram above represents the circular flow between households and firms. There are four flows in the above diagram. First, flows of factors of production (land, labour, capital, entrepreneurship) from households to firms. Second, flow of incomes (rent, wages, interest, profit) from firms to households. Third, flow of output (goods and services) from firms to households. Fourth, flow of spending/expenditure from households to firms (the household will buy the goods and services from the firm).

There are two movements of funds in the circular flow income. These are “withdrawals and injections”. Withdrawals will happen if there are changes of funds going out of the circular flow of income. Injections will happen if there are changes of funds going into the circular flows of income. The government is the reason of having withdrawals and injections in the circular flow of income.