Circular flow of income: two-sector model

In the two-sector model, households receive income from firms for supplying factors of production. They use part of this income for consumption and save the remainder. The saved portion is not immediately returned to firms as consumption expenditure, so it withdraws purchasing power from the current circular flow and is called a leakage. Investment spending by firms is the corresponding injection. Thus, saving is classified as a leakage, even though it may later finance investment through financial institutions.

Saving is the part of household income that is not spent on currently produced consumer goods and services. In the circular-flow diagram, this unspent amount reduces the monetary stream of consumption expenditure moving from households to firms; therefore it is a leakage from the monetary flow. The question does not describe a tax or import because the model contains only households and firms. Firm investment is the relevant injection that can offset saving.

Household income has two broad uses in the simple two-sector model: consumption and saving. Consumption expenditure returns money to firms and supports the circular flow, whereas saving is temporarily withheld from expenditure on current output. For this reason, saving is called a leakage from the circular flow. Investment by firms is an injection and may restore the balance. Government expenditure, taxes, exports, and imports belong to models with additional sectors.

Households own or supply the factors of production—labour, land, capital, and entrepreneurial ability—to firms. The movement of these productive resources is a real flow because it concerns actual services and resources, not money. Firms use them to produce goods and services, which move in the opposite real direction, from firms to households. Wages, rent, interest, and profit move from firms to households as monetary factor income, while consumption expenditure moves in the reverse monetary direction.

Consumption expenditure is a payment made by households to firms when households purchase goods and services. Because it consists of money moving between the two sectors, it is a money flow. Factor services and goods themselves are physical or real flows, not money flows, even though money payments accompany them.

A real flow refers to the movement of physical goods or productive services rather than money. Households own factors such as labour, land, capital and entrepreneurship, and they supply their services to firms for production. Wages and other factor payments are money flows in the opposite direction, while final goods flow from firms to households.

Households supply the services of labour, land, capital and entrepreneurship to firms. Firms compensate households for these services through wages, rent, interest and profit. Thus, factor payments are the corresponding money flow and move from firms to households, opposite to the real flow of factor services.

The relationship is National Income = Domestic Income + NFIA. Since NFIA is negative ₹50, it must be added algebraically as −₹50, which reduces domestic income. Thus, National Income = ₹1,180 + (−₹50) = ₹1,130. Option B is correct. A negative NFIA means that factor payments flowing to foreign residents exceed factor income received from abroad, creating a deduction from domestic income.