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 significant 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. In the factor market, businesses purchase the items needed to produce goods or services, including 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 who sells his services to Sandra. Sandra’s expenditure is Ben’s income. Ben uses some of Sandra’s payment to pay George, whose wages are income to George but an expenditure for Ben. Additionally, Ben purchases parts from a local auto parts store. His purchase is an expense to Ben, but it is also an income for the auto parts store. Fortunately, some of Sandra’s payment remains as income for Ben.
A simple model excludes the government, but when the government is added, the flows are altered while income still equals expenditures. Like the private sector, the government goes to the factor market to hire workers. It 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).
