What is the Circular Flow Of Income?

Learn about the circular flow of income, the model of the circular flow of income, and why it is important for an economy to grow.

The circular flow of income is a simple model that helps to understand economic activity. This model establishes the relationship between households, companies, and the government of an economy. These entities maintain a closer relationship than might be perceived, constituting the circular flow of income (a model that seeks to explain how these three economic entities are related).  

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Content

• What is the Circular Flow Of Income?
• Understanding The Circular Flow Model
• Types of flows
• Explaining the Circular Flow of Income Model
• Important Factors
• Participants in the Circular Flow of Income
• Key Takeaways

Let’s understand how the circular flow of income works –

A company sells its products to customers in exchange for money (the same money obtained by households working in different companies). The company’s income is distributed in: payment of inputs to other companies, payment of salaries, and the payment of interest on credits received and profits.

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Households represent the demand for the companies’ products and provide labor and capital inputs. On the other hand, companies create goods they sell to these households while paying their employees who are a part of the household to cover their needs.

It is possible to determine the value added or the final demand of the companies if we subtract the companies’ intermediate demand from the households’ demand.  

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Understanding The Circular Flow Model

The primary purpose of the circular flow model is to understand how money moves in the economy. It breaks down the economy into two main actors: households and companies. It divides the markets in which these actors operate as markets for goods and services, as well as for factors of production. 

The circular flow model begins with the household sector, which participates in consumer spending (C), and the business sector, which produces goods.

Two other sectors are also included in the circular flow of income: the government sector and the foreign trade sector. The government puts money in the circle through public spending (G) on programs like Social Security and the National Park Service. Money also enters the circle through exports (X), which bring in money from foreign buyers.

Also, firms that invest (I) money to buy fixed capital contribute to the flow of money in the economy.

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Explaining the Circular Flow of Income Model

In a simplified way, the economy comprises companies that produce and hire people and households that buy products and work for the companies.

Image – Circular Flow of Income Model

• On the right side of the model, we have business firms. Companies pay wages to people in exchange for work.  
• On the left side, we have the households that work with these firms. In exchange, they receive salaries, with which they pay off their expenses, rent, and interest.
• Following from right to left. Families with the income they earn pay in the product market in exchange for obtaining goods and services.
• Finally, the last payment. That is, what families pay in the product market goes to the companies that have provided goods and services to the product market.

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Types of flows

According to François Quesnay, in every economy, two types of flow guarantee its operation: the real flow and the monetary or financial flow.

• Real flow: Real flow refers to the factors of production and goods and services.
• Monetary flow: The monetary flow is the money that goes from some agents to others in exchange for those factors of production or goods and services.

We can see an example of this daily when we shop. On the one hand, we have the actual flow when we buy or acquire goods and/or services. On the other hand, we observe the monetary or financial flow when we pay for those purchases.

Important Factors

A nation’s circular income flow is said to be balanced when withdrawals equal the introduction of income into the flow. That is:

• The level of income introduced is government spending (G), exports (X), and investments (I) added together.
• The level of withdrawal from the flow is taxation (T), imports (M), and savings (S), added together.

If G + X + I is greater than T + M + S, the national income (GDP) level will increase. National income will decrease when the total withdrawal from the flow is more than the total injected into the circular flow.

Who Participates in the Circular Flow of Income?

As we have already indicated, the circular flow of income represents the movement of money within an economy. It shows who buys and sells, who saves, and how the government affects each transaction. Therefore, this circular flow model includes consumers (those who buy goods, individuals, and families), producers and/or companies (those who manufacture goods or provide services), and the government (public sector undertakings, (financial institutions, etc).

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Key Takeaways

• The circular flow model demonstrates how money passes from producers to households and vice versa in an infinite loop.
• In an economy, money passes from producers to workers through wages and returns from workers to producers since the workers spend money on products and services.
• Models can be more complex to accommodate more additions to the money supply, such as exports, and leakages from the money supply, such as imports.
• When all these factors are added together, the result is a country’s gross domestic product (GDP) or national income.
• An analysis of the circular flow model and its impact on GDP can enable governments and central banks to adjust monetary and fiscal policies to improve the economy.

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This model is helpful because it helps us understand why it is vital for all members of society to have a job. Even though many people would rather be unemployed than work in a job that pays poorly or does not interest them (or both).

The cycle length affects the amount of money circulating in an economy at any given time and, therefore, the amount of money available to invest and spend. If there is minimal (or no) circulation in the system, there will not be enough to go around. On the other hand, if there is less circulation, there will be problems with having more than what consumers can invest or spend.

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