Circular Flow of Income:

The diagram shows Real Flow (goods and services) and Monetary Flow (Income and expenditure).

The bottom pair of arrows depicts the goods market. In this market, households exchange money for the goods and services estimates national income from the product/output side. The other arrow shows the expenditure approach. The summation of these expenditures represents the expenditure approach).

The top pair of arrows represents the factor market in which the firms exchange money for services provided by the households, that is, wages-payment for labour services, interest for capital, rent for land and profit for enterprise. This look at national income represents the incomes earned by factors of production for producing the economy’s goods and services.

The circular flow diagram shows that national income may be measured by final output or product (Product or Output Method), final incomes (Income Method) and final expenditure (Expenditure Method)

The diagram gives us the basis national income identity: National Income National Product National Expenditure. This identity means that actual incomes received in the economy are identity to both actual expenditure and actual output or product produced in the economy.

The importance of this identity, is that it allows national income statisticians to decide on the best method to use for the estimation of a country’s national income. Having taken into account the strengths and the weaknesses of the three approaches as well as the conditions prevailing in and specific to the country the statistician decides on which method(s) to use.