Politics & Society

Understanding the Circular Flow Model in Economics

Written by MasterClass

Dec 21, 2018 • 4 min read

The economy can be thought of as two cycles moving in opposite directions. In one direction, we see goods and services flowing from individuals to businesses and back again. This represents the fact that, as workers, we go to work to make things people want or provide a service that people need.

In the opposite direction, we see money flowing from businesses to households and back again. This represents the money we pay for the things we want with the income from the work that we do.

The key takeaway is that both cycles are needed to make the economy work. When we buy things, we give up money for the things we want. When we go to work we make things in exchange for money.

The circular flow model attempts to distill the idea outlined above and show the flow of money and goods and services in a capitalist economy.


What Is the Circular Flow Model?

The circular flow model is an economic model that shows the flow of money through the economy. The most common form of this model shows the circular flow of income between the household sector and the business sector. Between the two are the product market and the resource market.

Households need goods and services, which businesses provide to them through the product market. In order to produce goods and services, businesses need resources. Members of households provide labor to businesses through the resource market. Businesses turn those resources into goods and services.

The 4 Factors of Production

There are four types of resources, known as factors of production. Each factor of production has a unique type of payment associated with it, called factor payments.

1. Labor

These are workers. Payment for labor is called “wages.”

2. Land

This is not just land to rent or own, but is more broadly defined as natural resources. Payment for land is called “rent.”

3. Capital

This is the money used to buy tools used by the labor to form the land (natural resources) into a good. Payment for capital is called “interest.”

4. Entrepreneurs

The people who put the other three together. Payment to entrepreneurs is called “profit.”

Costs, Revenue, and Consumer Spending

In the simple circular flow model of the free market, money flows in the opposite direction.

When households need a good or service, money flows from them to the product market (this is called consumer spending). The product market needs goods to provide to households, so it buys them from businesses (this is called revenue). The businesses need to be able to make those goods and services to provide to the product market, so they buy resources from the resource market (this is called cost). And finally, the resource market needs to buy resources from the households in the form of paying workers or renting land (this is called income).

Consumer spending —> Revenue —> Cost —> Income

This is the basic circular flow matrix.

The 3 Factors That Aren’t in the Circular Flow Model

While the basic circular flow matrix explains basic supply and demand in a simplistic economic vacuum, this model doesn’t take into account factors like:

1. Government Sector

Government is an important factor since it both injects money into the flow and also takes money out of it (called “leakage”).

Government Spending

The government buys things from the product market, like garbage trucks or aircraft carriers, and it also buys things from the resource market, like teachers or fuel. Payments the government makes to both the resource market and the product market are called “government spending.”

The government uses those goods, services, and resources to provide things for the overall economy, like education, roads, and protection—these are called “public goods.” Government spending can also be a public good, in the form of subsidies to businesses (as a way to promote them to manufacture more of a specific type of good) and welfare to households (as a way to help alleviate poverty).

Taxes (Sales, Income, Property, and others)

There are multiple ways the government spends money and hands money out in this circular flow model, but the government is also a cause of leakage—it takes money through taxes. The government taxes households and businesses in the form of income taxes and sales taxes. Because of this leakage, the government is able to inject money into the economy in other ways.

2. Financial institutions (banks)

Financial institutions are the source of another leakage, through household and business savings. This is money that would have otherwise flowed into the economy that is taken out semi-permanently. The financial sector injects money into the economy through investment and loans, which can help both the household sector and business sector.

3. Foreign sector (imports and exports with other countries)

The foreign sector typically injects and leaks goods rather than money. Goods flow into the circular flow model in the form of imports, and flow out of the model in the form of exports.

While a model with just the household sector and the business sector, with the product and resource market acting between the two, is the most simple version of the circular flow model, it does not provide a complete picture of the economy. Once the government, financial institutions, and the foreign sector are all added into the model, we get a more entire and accurate model of the economic system as a whole.