Explain the two sector model of the circular flow of National Income.

Answer: In a two sector economy, income flows in a circle between households and firms.

Assumptions: There are only two sectors, households and firms; there is no government and no foreign trade; households spend their entire income on consumption (no saving); firms sell their entire output to households.

Explanation:

1. Real flow: Households own the factors of production (land, labour, capital, entrepreneurship) and supply factor services to firms. Firms use them to produce goods and services and supply these to households.
2. Money flow: Firms pay factor incomes (rent, wages, interest and profit) to households. Households spend this income on buying goods and services from firms, which becomes the firms' revenue.
3. Thus the factor market links factor services and factor payments, and the product market links goods and consumption expenditure.
4. Since all income is spent, total income = total expenditure = value of total output, and the flow continues at the same level without any leakage.

[Diagram: two boxes, Households and Firms. The outer loop shows factor services from households to firms and goods and services from firms to households (real flow); the inner loop shows factor payments from firms to households and consumption expenditure from households to firms (money flow).]