The two sector economy consists of household J and business firm. The income is circulated between household and business firm. It is explained with the help of following diagram.
In every economy there is household sector on one hand and business firm on the other hand.
(A) Household is the basic consuming unit. It centres around a family. Its main function j is to consume goods and services. Business firm is the basic producing unit. Its main function is to produce goods and services with the aim of maximising profits. When s the household supplies factor services (land,labour,capital,enterprise to business firms, business firms supply goods and services to the household. This is known as Real Flow.
(B) In a money economy when the household supplies factor services, there is a flow of income from the business firm to the j household in form of rent, wages, interest and profit. This income comes from the firms to the household sector. The household ; sector uses this income to satisfy the wants. Therefore, there is a flow of consumption expenditure from the household to the business firms. The flow of factor payments from business sector to household sector and corresponding flow of consumption expenditure from household sector to business firms. This is known as Money Flow. Both the money flow and real flow should balance for the smooth functioning of the economy. If the money flow is greater j than real flow there would be inflation and if the money flow is less than the real flow there would be deflation.
(C) In the above diagram, the inner circle represents the Real flow and the outer circle represents the Money flow. There is circular and continuous flow of money income as production is a continuous activity due to never ending human wants. The circular J flow shows interdependence in the economy.
