The Circular Flow Model in Economics Explained (with diagrams)

The Circular Flow Model uses one of the most well-known diagrams in economics to illustrate how income, expenditure, products, and inputs circulate through an economy. It is one of the first concepts that will be introduced to students of macroeconomics.

It is a fairly basic model, but it does give an important overview of how all the important ingredients of national income and output interlink with each other. The circular flow model is not a static model i.e., it is not a snapshot of a moment in time, it is a dynamic model that illustrates the workings of the economy over time.

Most textbook introductions of the model start with a simple division of an economy between households and business, and I will copy that format here. Following on from that, I’ll illustrate the full circular flow model with saving & investment, the government, and foreign trade added in.

The Basic Circular Flow Diagram

The basic circular flow diagram illustrates how households provide inputs i.e., factors of production, to businesses in return for money. That money is then spent in the form of consumer expenditure, meaning that the money flows back to businesses, in return for which those businesses supply households with goods and services.

These flows are indicated starting with the bottom yellow arrow in the circular flow diagram below, through to the top orange arrow respectively.

In order to complete the basic model, we need to account for the saving and investment flows of households and businesses, the actions of government, and the nature of foreign trade. I will do this shortly, but first let’s briefly discuss the flows between households and businesses in a little more depth.

The Circular Flow of Income and Expenditure

The nature of the circular flow of income and expenditure is such that there is no beginning or end, but it may be convenient to imagine a start point where households provide the factors of production to businesses.

The most obvious example of this would be people going to work, but it also includes landowners making their open for lease, and rental income. Similarly capital owners can make their resources available in return for interest payments, and entrepreneurs make themselves available for the pursuit of profit. All these factors reside within households until they are put to use in business.

The expenditure side of things is more straightforward. All people are consumers and all expenditure is done to maximize consumption i.e., to gain the maximum utility from the goods and services that their incomes can afford. This relates to the basic economic problem of scarcity, and how best to satisfy our unlimited wants; attaining the highest level of consumption now and in the future is our ultimate aim in economics.

What are the 5 sectors in the Circular Flow Model?

Moving towards a more complete version of the model, there are a total of 5 sectors in the circular flow model to explain. The first two, households and businesses, are already explained above.

• Households – Households are composed of people, and people play the role of consumers on the one hand, and workers, land owners, capital owners, and entrepreneurs on the other hand.
• Businesses – Businesses are those organizations that bring together, and pay for, the factors of production. These businesses produce the output, i.e. goods and services, that are then sold to consumers.
• Banking & Finance – The financial services sector is usually treated separately from other businesses because economists give particular attention to the saving and investment flows that they channel.
• Government – Government includes local, state and federal institutions. It also includes all government funded institutions e.g., public hospitals, education services, highway maintenance, national defense and so on.
• Foreign Sector – This includes the foreign goods and services that domestic consumers purchase from foreign businesses. Conversely, it also includes the domestically produced output that is sold to foreign consumers.

We should be clear at this point that there is often some overlap between these sectors. Some businesses can work for both the private sector and the government sector, as can the people who make up households.

There is also some controversy as to whether or not the banking and finance sector should be given special attention, and some of the standard economics textbooks do not do so. Nevertheless, those same textbooks do give a great deal of attention to saving and investment flows, so it pays to give a little extra detail for completeness.

As with the other sectors, there is significant overlap in the banking and finance sector, and a great deal of the activity in this sector is conducted across international borders. In fact, as discussed in my article about Balance of Payments Accounting, international capital flows work to partially or completely offset any trade surplus or deficit resulting from the foreign trade flows of imports and exports (depicted in the graph below).

The Full Circular Flow Model with Leakages and Injections

The full circular flow model includes leakages and injections from and to the domestic economy. It also adds the extra sectors that account for those leakages and injections i.e., government, foreign trade, and the banking and finance sector.

Leakages:

• Taxes – Taxes are a leakage from the circular flow model because they are either directly taken from income, or they are levied on goods and services thereby making them more expensive. As a result, consumer spending i.e., consumption, is reduced.
• Imports – Imports do not reduce consumption directly, and they actually increase total utility since consumers prefer them to the goods & services which they would otherwise have bought. However, once money is paid to foreign businesses, it exits the domestic economy and, ceteris paribus, reduces the circular flow in future periods.
• Saving – If consumers choose to save money rather than spend it, business output will go unsold and production will be reduced. This will in turn reduce the demand for the factors of production and thereby, ceteris paribus, reduce income. This is known as the paradox of thrift.

Injections:

• Government Spending – Government spending is the flip-side of taxes, and increases the size of the circular flow. The extent to which this type of spending compensates for reduced consumer spending is hotly debated in economics, but there is no doubt that a great deal of inefficiency exists here.
• Exports – Exports are an injection into the domestic circular flow model in the same way that imports are an injection into foreign circular flow models. As alluded to above, imports and exports do not necessarily equal themselves out, and where there are deficits or surpluses then international borrowing and exchange rate movements settle the difference.
• Investment – Investment is often cited as the flip-side of saving, and in a financial system with full reserve banking and interest rates set by the market this would indeed be the case. However, the real world runs on credit, and credit often funds investment rather than saving. Nevertheless, there is still a link between saving and investment levels. Investment is an injection into the model, and is linked to future economic growth.

Final Thoughts and Criticisms

The Circular Flow Model is one of the most basic models in macroeconomics, and it cannot provide anything close to a full overview of all the machinations in a complex real-world economy. All economic models are abstractions that serve to highlight some basic features of reality, and this model is no exception.

The details of how the complex interplay of one phenomenon interacts with another is left to more specific models, but for a general overview of how money circulates around the economy, the model presented here is sufficient.

One weakness of the circular flow model relates to the role of the banking and financial system, which is far more complex than is presented here. The model also fails to illustrate how interest rates, exchange rates, debt, and international capital flows influence the economy. These are major influences on any developed economy, and it is a fair criticism to note how any explanation of them is absent from the model.

Another significant weakness of the circular flow model is that it gives no account for inequality in the economy, all factors are assumed to be homogeneous, and even people are assumed to be the same. In the real-world there is a great deal of inequality, my article about the Gini-Coefficient discusses this in some detail.

Related Pages:

• National Income Accounting
• The Factor Market vs Product Market
• The Business Cycle
• The Economics of Decline

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