Explain the Interaction Between Households and Firms Through a Circular Flow diagram.
Circular flow of income in a two sector economy: (Without Financial Sector): In two sector economy, it is assumed that government has no interference. Economy is a closed economy and has no economic relations with the rest of the world.
Hence, there are two sectors only: households and firms. Households provide factors of production to the firms who in return pay for them. Firms provide goods and services to the households who pay firms for them. Flow of money from one sector to other is called monetary flow. The flow of goods and services from one sector to other is called real flow. Real flow is equal to money flow. It is shown with the help of following diagram: