Circular Flow Model

The circular flow model demonstrates how money moves through society. Money flows from producers to workers as wages and flows back to producers as payment for products. In short, an economy is an endless circular flow of money.

That is the basic form of the model, but actual money flows are more complicated. Economists have added in more factors to better depict complex modern economies. These factors are the components of a nation’s gross domestic product (GDP) or national income. For that reason, the model is also referred to as the circular flow of income model.

The basic purpose of the circular flow model is to understand how money moves within an economy. It breaks the economy down into two primary players: households and corporations. It separates the markets that these participants operate in as markets for goods and services and the markets for the factors of production. Other sectors can be added for more robust cash flow tracking.

The circular flow model is used to measure a nation’s income, as the circular flow model measures both cash coming into and exiting a nation’s economy. It is also used to gauge the interconnectivity between sectors as a fully robust and strong economy will have interaction between components. For instance, the relationship between a government’s taxation policies and a household’s consumption spending will have a direct impact on a business’s ability to sell goods.

The circular flow model is aptly named because funds tend to continuously flow between sectors. As highlighted in the diagram below, money often flows from one sector to another, awarding benefits along the way. No single sector should hoard or collect all resources; instead, a fully-functioning circular model will continuously move funds so each sector can operate appropriately. Note that this example below is a single type of model and does not represent all circular flow models.

There are different types of circular flow models, each with a different number of sectors it tracks. Below are the potential sectors that could be included in a circular flow model. Each sector within a circular flow model may be designated with a capital letter often used to describe how to calculate GDP.

In a two-sector model, circular flow models start with the household sector that engages in consumption spending (C). Households contribute to an economy by working (giving away time and labor) and by buying products (giving away money). In return, households consume products and utilize government programmes.

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