Understanding the Circular Flow Model: A Comprehensive Guide to What It Is and How It Works If you're looking to learn more about the economy, keep reading for a comprehensive guide to the circular flow model.
By Entrepreneur Staff •
Are you interested in learning more about the US economy and the capitalist economic system? The circular flow model is a way to understand its ebbs and flows better, as it helps to visualize the interactions between different actors in the economy and how they influence the overall level of economic activity.
Keep reading for a comprehensive guide on the basic model of capitalist economies, including:
- What the circular flow model is
- The components of the circular flow model
- The circular flow model's limitations
- The applications of the circular flow model
What is the circular flow model?
The circular flow model is a way to show the flow of money, goods and services in an economy. It shows people earning money by working for businesses and then spending it on the things they need and want from those businesses.
The circular flow model represents the economy and its actors:
- Household sector: This sector represents all the individuals or families that make up the economy. They provide labor, resources and capital to the firms in exchange for wages, profits and rents.
- Firm sector: The firm sector represents all the businesses that produce goods and services in the economy. They use the resources provided by the households to produce the goods and services sold to the households and the government.
- Government sector: This sector represents the government and all the public institutions involved in the economy. The government provides goods and services to households and firms and collects taxes from households and firms.
- Foreign sector: The foreign sector represents all the actors outside the domestic economy, such as foreign countries, international organizations and international trade. The foreign sector plays a role in the economy by trading goods, services and capital with the domestic economy.
- Financial sector: This sector represents the financial institutions, such as banks and other intermediaries, that are involved in the economy. They facilitate the flow of capital between households, firms, the government and the foreign sector.
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What are the types of circular flow models?
While the two-sector circular flow model is the most common type, other more complex models exist.
Other types of circular flow models include:
- Two-sector model: Households and firms are the participants.
- Three-sector model: Households, firms and government are the participants, and the model depicts the flows of goods, services and money between households, firms and the government.
- Four-sector model: Households, firms, the government and the foreign sector are the participants, and the model shows the flows of goods, services and money between households, firms, the government and the rest of the world.
Some more elaborate models include financial markets and other institutions, but these models can become quite complex and are typically used by economists to study specific economic issues.
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Circular flow model: What are injections and leakages?
Injections
Injections are additional inputs to the flow of goods, services and money and are visually represented by arrows pointing into the circular flow.
The following are examples of injections:
- Investment spending by firms: This is the spending by firms on new capital goods, such as machinery and equipment, that increases their ability to produce goods and services.
- Government spending: This refers to spending by the government on goods and services, such as public infrastructure and social services, that increases the flow of goods and services in the economy.
- Exports: This is the sales of goods and services by firms to foreign buyers, which increases the flow of goods and services in the domestic economy.
Leakages
Leakages, or withdrawals, are subtractions from the flow of goods, services and money and are visually represented by arrows pointing out the circular flow.
The following are examples of leakages:
- Saving: This refers to the portion of national income not spent on consumption, which reduces the flow of goods and services in the economy.
- Taxes: These are payments made by households and firms to the government, reducing the flow of public goods, services and money in the economy.
- Imports: This refers to purchases of goods and services by households and firms from foreign suppliers, which reduces the flow of goods and services in the domestic economy.
In a healthy economy, injections must equal leakages to maintain the circular flow. In other words, for the flow of goods, services and money to continue, there must be enough injections to offset the leakages.
If injections exceed leakages, the economy will grow, and if leakages exceed injections, the economy will contract.
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How does the circular flow model relate to gross domestic product?
Gross domestic product (GDP) is another critical term you will come across when researching the economy. GDP measures the total value of goods and services produced in an economy in a given period, usually a year.
The circular flow model and GDP are related because the model provides a visual representation of the transactions that make up GDP.
In the circular flow model, the value of goods and services produced equals the sum of household consumption, investment by firms, government spending and exports minus imports.
The circular flow model is a way of visualizing GDP transactions and understanding how they are interconnected.
Related: What Causes Inflation? Everything You Need To Know.
How do you calculate GDP?
There are three ways to calculate GDP, but the most common method is the expenditure approach, which calculates GDP as the sum of the following four components:
- Consumption (C): The spending by households on goods and services, such as food, clothing, housing and medical care.
- Investment (I): The spending on capital goods, such as machinery and equipment, and on structures, such as buildings and roads
- Government spending (G): The spending by the federal, state and local governments on goods and services, such as national defense, education and healthcare
- Net exports (X - M): The difference between exports (X), which are goods and services produced in the country but sold to foreigners, and imports (M), which are goods and services produced abroad but sold in the country
GDP can be calculated using the following formula:
- GDP = C + I + G + (X - M)
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What is a real-world example of the circular flow model?
To better understand how the circular flow model works in the real world, see the step-by-step process below:
- Households receive income from wages, salaries or other forms of compensation.
- With their income, households buy goods and services from firms (comprising the product market), which is called consumption and represents the most significant part of the circular flow.
- Firms use the money they receive from household consumption to pay for factors of production, like labor, raw materials and capital goods.
- Factors of production comprise the factor market and receive income in the form of wages, rent and profit. With this income, they purchase goods and services from firms and households.
- Some households and firms save a portion of their income, meaning that money is not spent on consumption or investment. This represents a leakage from the circular flow, as it reduces the amount of money available for spending on goods and services.
- The government collects taxes from households and firms, which represents another leakage from the circular flow.
- The government then uses this money to finance its spending on goods and services, such as public infrastructure, education and healthcare.
- Firms use some money from sales to households to invest in new capital goods, such as machinery and equipment. This investment represents an injection into the circular flow, as it increases the amount of money available for spending on goods and services.
- Finally, some of the goods and services produced in the economy are exported to foreign countries, which represents an injection into the circular flow. At the same time, the economy also imports goods and services from foreign countries, which means a leakage from the circular flow.
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What are the limitations of the circular flow model?
Again, the most commonly used circular flow diagram is the two-sector model. While the two-sector circular flow model is a great tool that provides a simplified representation of the economy, it does have its limitations because of its simplicity.
See some of its most significant limitations below.
Ignores the financial sector
The circular flow model does not consider the role of the financial sector, including banks, insurance companies and other financial intermediaries.
In reality, the financial sector plays a crucial role in directing funds from savers to borrowers and influencing investment and consumption.
Does not account for the international sector
The circular flow model assumes a closed economy, meaning it does not consider the trade of goods and services with other countries.
In reality, the international sector is an essential component of the economy, and trade balance changes can significantly impact economic growth and stability.
Ignores distribution of income
The circular flow model does not consider income distribution among households, firms and factors of production.
In reality, the circular flow of income is not distributed equally, which can affect the level of consumption, investment and overall functioning of the economy.
Does not reflect the complexity of the real economy
The two-sector circular flow model is a simplified representation of the real economy. It does not reflect the complexity of the relationships between households, firms, factors of production and the government.
In reality, many interconnections and feedback loops can affect the flow of goods, services and money.
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What do you need to know about the circular flow model?
The circular flow model is a fundamental economic concept visually representing the flow of goods, services and money between different economic actors.
The relationship between GDP and the circular flow model is also essential to understand, as the circular flow model visualizes the transactions that comprise GDP.
Overall, the circular flow model is a valuable tool for understanding the basic functioning of the economy, and it provides a foundation for further study in economics and related fields.
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