In the circular flow of income households and firms interact with each other in order to determine the equilibrium level of output. Households supply factors services to the firms and in return receive factor incomes like wages, rents , interests and profits. Thus there is a flow of factor services from households to firms and money flow from firms to households. Households spend their income to purchase goods and services produced by firms. So, there is a flow of goods from firms to households and in return there is a flow of money from households to firms. This flow of money from firms to households and again from households to firms is known as circular flow of income.
In this case , we assume that households spend all their incomes by purchasing goods and services produced by the firms, firms keep the production equal to sales and the firms pay out to households all the money they receive from the sale of goods. So the size of flow remains the same. All the money received by one group is passed on to the other. Nothing is taken away from the flow or nothing is added to the flow. Hence the size of the flow always remains the same. This is the situation of neutral equilibrium. In neutral equilibrium there is neither withdrawals nor injections into the circular flow because any withdrawal reduces the size of flow and any injection increases the size of flow. So, in order to attain equilibrium even if there is injection and withdrawal, the volume of injection must be equal to the volume of withdrawals. Again, if households save any part of their income then saving comes under withdrawal from the circular flow and in the same way the firm's investment expenditure for producing capital gods and services is an injection to the circular flow. So, equilibrium is achieved when planned saving equals to planned expenditure. In this way, equilibrium level of income is explained with circular flow of income.
Works Cited
Salvatore , Dominick. Microeconomics Theory and Applications: Oxford, 2003.
.Cheung, Vanessa. “The Circular Flow of Income Explained.”(2013): www.romeceonomics.com/circular-flow-income-explained
