Circular Flow Model

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Definition of the Circular Flow Model:

The circular flow model is a model that depicts how goods and services flow in exchange for money.

Detailed Explanation:

Economists use the circular flow model to show the interdependent relationships between households, producers (businesses), and government. This diagram depicts how goods and services flow in exchange for money. The two major actors in the circular flow model are households and businesses. They trade with each other in two markets—the factor market and the goods and services market. The factor market is where businesses go to purchase the items needed to produce goods or services. These factors include entrepreneurs, land, natural resources, labor, and capital. The goods and services market is anywhere businesses sell goods and services to the final consumer. Figure 1 illustrates how households and businesses interact in the goods and services and factor markets in exchange for money.

The circular flow model illustrates how in an economy income must equal production. In other words, one person's expenditure is another entity's income. For example, Ben is a mechanic. He sells his services to Sandra. Sandra's expenditure is Ben's income. Ben uses some of Sandra's payment to pay George. George's wages are income to George, but an expenditure to Ben. Ben also purchases parts from a local auto parts store. His purchase is an expense to Ben, but income to the auto parts store. Fortunately, some of Sandra's payment is left over as income to Ben. 

A simple model excludes the government, but when the government is added the flows are altered, but income still equals expenditures. The government goes to the factor market to hire its workers, just like the private sector. The government hires companies through the goods and services market, just like households. Like businesses, the government provides (sells) goods and services to businesses and households in return for money (taxes).


Here's a fun video explaining this concept more.

Dig Deeper With These Free Lessons:

Circular Flow Model – We Depend On Each Other
Economic Systems
Factors of Production – The Required Inputs of Every Business
Supply and Demand – Producers and Consumers Reach Agreement
Business Cycles

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