Which of the following statement is true in the context of circular flow of money in a simple economy ?

Statement 1 : There is only one way in which the households may dispose off their earnings – by spending their entire income on the goods and services produced by the domestic firms.
Statement 2: In a simplified economy, the aggregate consumption by the households of the economy is less than the aggregate expenditure on goods and services produced by the firms in the economy.

Statement 1 is true and statement 2 is false

The correct answer is Option 3:  Statement 1 is true and statement 2 is false

Statement 1 : In a simplified economy, there is only one way in which the households may dispose off their earnings – by spending their entire income on the goods and services produced by the domestic firms. This is correct. The other channels of disposing their income are closed assuming that that the households do not save, they do not pay taxes to the government – since there is no government, and neither do they buy imported goods since there is no external trade in this simple economy. In other words, factors of production use their remunerations to buy the goods and services which they assisted in producing.

Statement 2: The aggregate consumption by the households of the economy is less than the aggregate expenditure on goods and services produced by the firms in the economy in a simple economy. This is incorrect. The aggregate consumption, in a simplified economy, by the households of the economy is equal to the aggregate expenditure on goods and services produced by the firms in the economy.). The entire income of the economy, therefore, comes back to the producers in the form of sales revenue. There is no leakage from the system – there is no difference between the amount that the firms had distributed in the form of factor payments (which is the sum total of remunerations earned by the four factors of production) and the aggregate consumption expenditure that they receive as sales revenue.