Circular Flow of Income:

There are basically three economic agents  in the economy: households, firnls and government. The households receive income  by selling their  labour  and capital inputs  in the factor market. This income is used on three heads:

i) payment of taxes to the government,

ii)  consumption  of goods  and services, and

iii) saving through  financial markets.

Firms  use  the  revenue  obtained  by selling goods  and dces  for factor  payment. The government receives revenue  from taxes, which is used for purchase of goods  and services.  If government revenue  is  less than  its  purchases  (that means  ifthere  is a detail') then the government  borrows from the financial markets.  

Thus  there is a circular flow of  income and expenditure from one economic  agent  to others  in a  closed economy. If  foreign trade is allowed, the model presented at Fig. needs modification  and external sector  needs  to be introduced. Remember that the circular flow  depicted  in Fig. is  a simplification  of  reality even for a closed  economy. Here we assume  that households own  labour and capital. In practice, firms also own  capital, make investment, and pay taxes  to  the government. Government transfers money to households as  social security measures.