Understanding the Circular Flow Model in Economics

What Is the Circular Flow Model?

The circular flow model demonstrates how money moves through society. It flows from producers to workers as wages and flows back to producers as payment for products. An economy is an endless circular flow of money.

This is the basic form of the model, but actual money flows are more complicated. Economists have added more factors to better depict complex modern economies. They’re the components of a nation’s gross domestic product (GDP) or national income. The model is also referred to as the circular flow of income model for this reason.

Understanding the Circular Flow of Money

The basic purpose of the circular flow model is to understand how money moves within an economy. It breaks the economy down into two primary sectors: households and corporations. It separates the markets that these participants operate in as markets for goods and services and markets for the factors of production. Other sectors can be added for more robust cash flow tracking.

The circular flow model is used to measure a nation’s income, because it measures both cash coming into and exiting a nation’s economy. It’s also used to gauge the interconnectivity between sectors, because a robust economy will have interaction between components. The relationship between a government’s taxation policies and a household’s consumption spending will have a direct impact on a business’s ability to sell goods.

The circular flow model is aptly named because funds tend to flow continuously between sectors. This diagram shows how money often flows from one sector to another, awarding benefits along the way. No single sector should hoard or collect all resources. A fully functioning circular model will continuously move funds so each sector can operate appropriately. This example is a single type of model. It doesn’t represent all circular flow models.

Key Components of Circular Flow in Economics

Each type of circular flow model tracks a different number of sectors. These are the potential sectors that could be included in a model. Each may be designated with a capital letter that’s often used to describe how to calculate GDP.

Household

Circular flow models start in a two-sector model with the household sector that engages in consumption spending (C). Households contribute to an economy by working, giving away time and labor, buying products, and giving away money. Households consume products and utilize government programs in return.

Business

Circular flow models in a two-sector model also include the business sector, which produces the goods. Businesses absorb a variety of production costs, including labor, materials, and overhead. Many companies can manufacture products that benefit other parties as a result.

Government

Government sector cash flows are included in a three-sector model. The government injects money into the circle through government spending (G) on programs such as Social Security and the National Park Service. It also extracts money from households and businesses by way of taxes.

Foreign

Money also flows into the circle in a four-sector model through exports (X) that bring in cash from international buyers from the foreign sector. This indicates that the two-sector or three-sector models represent domestic activity only. The foreign sector is different from the domestic sector because there may be administrative inefficiencies that result in lost cash flow due to import taxes, duties, or fees.

Financial

Cash flow from the financial sector is added in a five-sector model. This includes banks and other institutions that provide cash flow via lending services. Some circular flow models also outline investor activity, because cash flow from entrepreneurs and investors might represent an inflow to businesses while net profits from the company represent an outflow.

Circular Flow Model: Injections and Leakages

Just as money is injected into the economy, money is withdrawn or leaked through various means as well. Taxes (T) imposed by the government reduce the flow of income. Money paid to foreign companies for imports (M) also constitutes a leakage. Savings (S) by businesses that otherwise would have been put to use are a decrease in the circular flow of an economy’s income.

A government calculates its gross national income by tracking all these injections into the circular flow of income and the withdrawals from it. The circular flow of income for a nation is said to be balanced when leakage equals injections:

• The level of injections is the sum of government spending (G), exports (X), and investments (I).
• The level of leakage or withdrawals is the sum of taxation (T), imports (M), and savings (S).

The level of national income (GDP) will increase when G + X + I is greater than T + M + S. National income will decrease when the total leakage is greater than the total injected into the circular flow. A country’s economy can theoretically sustain itself forever as long as its injections are greater than its leakages. The country must find additional cash flow to compensate for the shortage, however, if there are cash flow shortages/leakages.

Calculating Gross Domestic Product (GDP)

GDP is calculated as consumer spending plus government spending plus business investment plus the sum of exports minus imports. It’s represented as GDP = C + G + I + (X – M).

It would lead to a reduction in household spending and cause a decrease in GDP if businesses decided to produce less. It would lead to a reduction in business production, also causing a decrease in GDP, if households decided to spend less.

GDP is often an indicator of the financial health of an economy. A common although not official definition of a recession is two consecutive quarters of declining GDP. Governments and central banks adjust fiscal and monetary policy to boost growth when this happens.

Keynesian economics believes that spending leads to economic growth, so a central bank might cut interest rates, making money cheaper, so individuals will buy more goods such as houses and cars, increasing overall spending. Companies increase output and hire more workers to meet the increase in demand as consumer spending increases. The increase in employed people means more wages and more people spending, leading producers to increase output again, continuing the cycle.

Example of Circular Flow Model

Consider a circular flow model involving Apple employees and Apple product consumers. We’ll also include the government in this example to form a three-sector circular flow model.

There are several factors to consider from the household/consumer perspective:

• Households may spend money, and they get new, innovative technology products in return.
• Households may be employed by Apple. They may contribute labor hours and time to the company, resulting in Apple growing and becoming a more successful company.
• Households receive income from Apple, although part of this money is given to the government in taxes.
• Households then benefit from government programs.

The company exists to create products. It sells products and takes money from households. It also takes time from workers to make those products. A certain portion of the company’s profits is given to the government in the form of taxes. Apple may benefit from government programs or subsidies in some cases, so part of these tax dollars may indirectly benefit the company.

Both households and businesses pay taxes from the government’s perspective. These dollars are then used to deploy capital projects or public programming, both of which may benefit Apple, its employees, or its customers.

Additional sectors or additional flows could be added. Apple is an international company that sells goods around the world. Investors may also contribute money into Apple in return for a portion of the company. This example highlights the complexity of the circular flow model as inputs and outputs continually cycle throughout a systematic economy.

Explain Like I’m 5 Years Old

Economics involves many moving, interacting parts. A circular flow model can include at least six of them. There are two, however, at its simplest level: households and businesses.

Assume your 5-year-old self walks your neighbor’s dog daily and collects $5 for the service at the end of the week. You’ve contributed to the economy with your time spent, and you contribute again when you use that $5 you’ve earned to buy yourself a much-coveted treat. You’re the “household.”

Your neighbor has also contributed to the economy by leaving home each day and working, which they were able to do without worrying about having to walk their dog. Your service was a production cost, but your neighbor was able to provide a product or service to the economy with their labor. Your neighbor is the “business.”

The store that sold you the treat also benefited, as did your neighbor’s employer, who most likely gained financially because their business was able to provide a good or service thanks to your neighbor’s labor. Money, spending, and benefits moved around in an endless loop.

The Bottom Line

Our global economy is incredibly interconnected, and this is often graphically depicted using the circular flow model. The model details how resources flow into and out of households, businesses, governments, investors, markets, and foreign entities. This cycle shows how the resources of one sector are used to develop others in a cyclical manner.