(a) Discuss briefly the concept of circular flow of income in a two-sector model. (b) “Real Gross Domestic Product (GDP) is a better indicator of economic growth of a nation as compared to the Nominal Gross Domestic Product (GDP).” Do you agree with the given statement ? Justify your answer with a valid hypothetical numerical example.

Question

Accepted Answer

(a) In a **two-sector model**, only households and firms exist. Households supply factor services to firms and receive factor payments (rent, wages, interest, profit) in return. Households then spend this income on goods and services produced by firms. The flow of factor services and goods forms the **real flow**, while the flow of factor payments and consumption expenditure forms the **money flow**. In equilibrium, total income equals total expenditure.

(b) **Real GDP** is a better indicator because it measures output at constant prices, eliminating the effect of price changes. Nominal GDP can increase simply due to inflation without any actual increase in production. Real GDP reflects true changes in the volume of goods and services, making it more reliable for comparing economic growth across different time periods.