The circular flow model is a fundamental representation of macroeconomic activity among the major players in the economy--consumers, producers, government, and the rest of the world. Different versions of the model sequentially combined the four sectors--household, business, government, and foreign--and the three markets--product, resource, and financial--into increasingly more comprehensive representations of the economy. This article does not include the foreign sector. It will be discussed in a separate article.
The model below illustrates the simple, basic interaction between the household and business sectors through the product and resource markets.
Two Sectors, Two Markets:
The simplest circular flow model contains two sectors (household and business) and two markets (product and factor/resource). This model highlights the core circular flow of production, income, and consumption.
Total income is income received by households in payment for the production of these goods and services. The value of total output is identical to total income since spending by one group is income to another. Thus income earned by households equals their spending on consumption.
The circular flow of goods and services is a simplified illustration of basically two flows: the flow of incomes to households from firms, and the flow of resources to firms from households. Resources flow from households to businesses, which change the resources into goods and services for consumption in the product markets. Households are rewarded for the resources they provide in the form of money. It is a circular process that flows in both directions.
Three Sectors, Three Markets:
The second version of the model includes the government sector and the financial sector. You will notice that when household savings "leak out" of the circular flow and are deposited in the financial institutions. They are "injected" back into the economy in the form of business investments. Households also receive interest and dividend income form businesses.
While taxes take a portion of the household income out of the circular flow (leaks out as did the savings), that amount comes back to the circular flow as an injection in the form of purchases of goods and services that the government buys from the product markets and pays households as social security, Medicaid, welfare, etc
The government buys goods and services from private firms and pays wages and salaries to government employees. Since many government goods are not sold in the market place we value them at their cost when estimating Gross Domestic Product (GDP) which is explained and discussed later in a later article.
Leakages and Injections ModelLeakages: Household Savings and TaxesInjections: Government Purchases and Business Investments
The prime conclusion of the circular flow model is that the overall volume of the circular flow is largely unaffected by the path taken. In particular, household income can be used for consumption, saving, or taxes.
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