Assumptions in the circular flow of income in a two sector economy
- Existence of two sectors only. It is assumed that the economy has only two sectors that is households and firms. The households provide the factors of production while firms are involved in the production of goods and services.
- Total spending by households. It is assumed that the households spend all their income on the goods and services produced by the firms i.e. no savings.
- Total spending by the firms. It is assumed that the firms spend the money received from the sale of goods and services to pay for the rewards of production factors.
- Lack of government intervention. The government does not influence how the firms and households carry out their activities. Such interventions are in the form of taxes, price controls among others.
- Closed economy. Exports and imports do not exist in such an economy.