The circular flow model maps income, output and spending

The circular flow model in economics is a simplified map of exchange between households and businesses. It shows resources and goods and services moving through two markets, while money moves in the reverse direction as income, household spending and business revenue.

The model is deliberately narrower than a real economy. Its central insight is that household spending on goods and services becomes business revenue, while businesses make payments to obtain the resources used in production.

How to read the circular flow model

The basic diagram contains two decision-making groups and two markets. Households consist of one or more people living in the same housing unit. Businesses produce and sell goods and services. They meet in a resource market, also called a factor market, and a goods-and-services market, also called a product market.

The arrows represent two opposing flows. The real flow is the movement of resources and goods and services. The money flow records the payments associated with those exchanges. Households sell in the resource market and buy in the product market.

• Resource market, real flow: households supply resources to businesses.
• Resource market, money flow: businesses pay households income for those resources.
• Product market, real flow: businesses supply goods and services to households.
• Product market, money flow: households spend on goods and services, creating business revenue.

The resources households supply

In the basic model, households supply four factors of production: inputs used to make goods and services. Land includes natural resources. Labour is paid work. Capital means goods used in further production, such as tools, machinery or computers, rather than money. Entrepreneurial ability combines the other resources to bring goods or services to market.

Each input has a corresponding income category. Labour earns wages; land earns rent; capital earns interest; and entrepreneurial ability earns profit. These categories show how payments that are costs to a business are income to the households supplying resources.

One transaction around the circle

Consider a diner. A household pays for a meal in the product market, giving the diner revenue. The owner uses funds to buy potatoes and pay workers’ wages, among other production costs. The farmer and staff receive income through the resource market. Revenue remaining after production costs is profit for the entrepreneur.

When a recipient of that income spends on other goods and services, the basic sequence begins again. The example illustrates the relationship between production, income and expenditure that the model is designed to show.

Why the model is connected to GDP

Gross domestic product, or GDP, is the market value of final goods and services produced within a country’s borders during a given period. The circular flow diagram illustrates the closed-loop relationship between expenditure on final output and income earned in producing it: goods and services flow in one direction and income in the other.

In the broader expenditure approach, GDP is expressed as Y = C + I + G + X − M: household consumption, investment, government spending, exports and imports. The basic two-sector circular-flow diagram foregrounds households and businesses, so it does not display all of those categories.

GDP can also be measured through income, by adding wages, rents, interest and profits, and through value added at stages of production. The circular flow model helps explain the consistency between the income and expenditure views of output.

What the two-sector model leaves out

The two-sector version reduces the economy to households and businesses so that the underlying exchanges are clear. The real economy is more complex. Circular-flow models can add government, foreign and banking sectors, but those extensions require a more detailed diagram.

Frequently asked questions

What is the difference between real flow and money flow in the circular flow model?

Real flow is the movement of economic resources from households to businesses and of goods and services from businesses to households. Money moves in the opposite direction: businesses pay households income for resources, while households spend on goods and services.

What are the factor market and product market?

The factor, or resource, market is where households supply land, labour, capital and entrepreneurial ability and businesses buy those inputs. The product market is where businesses sell goods and services and households purchase them.

Why is capital a factor of production rather than money in the model?

Capital refers to goods used to produce other goods and services, including tools, machinery and computers. In the circular flow model, money is the means of payment, while capital is a productive resource.

How does the circular flow model explain GDP?

The model illustrates the closed-loop relationship between spending on final output and income earned in producing it. This supports the relationship between the expenditure and income approaches to measuring GDP; GDP can also be measured using a value-added approach.

Sources

• Circular Flow | Video Assignment — www.federalreserveeducation.org
• Lesson summary: The circular flow and GDP (article) — www.khanacademy.org
• Circular Flow Diagram In Economics | Think Econ — www.youtube.com
• The Circular Flow Diagram — wiki.ubc.ca