What is a Circular Flow Model?

What is a Circular Flow Model?

Definition

A circular flow model illustrates the movement of goods and services in an economy. Consumers, which are referred to as households, supply the factors of production to producers, which are called firms. The firms manufacture goods and services, which in turn, are sold to households.

What does circular flow model mean?

This model establishes the interdependent relationship between consumers and producers. To understand this model, it is important to appreciate:
  • Household or consumers are both buyers and sellers. They provide land, labor, capital, and entrepreneurship. In other words, they are sellers of these factors of production.Households are buyers too. They purchase the goods that firms manufacture and the services that they provide.
 
  • Firms are also both buyers and sellers. They buy the factors of production from households. The goods and services that they provide are sold to consumers.
Circular flow model   The circular flow model can also be explained in another way:
Production → Income → Expenditure → Production
The production activity carried out by firms provides income for households. The households utilize this income buy goods and services from firms. The expenditure that households make leads firms to produce more goods and service. In this manner, the circular flow of income is established.

Example of a circular flow model

The circular flow model can be understood by considering the economic activity in a country. The gross domestic product (GDP) of a country can be calculated in the following manner:
GDP = C + G + I + (X – M)
Where:
C = consumption, which is the expenditure by households on goods and services.
G = government spending
I = investments by firms
X = exports
M = imports
A change in any of these components will have an impact on GDP. For example, if consumption goes down, the country’s GDP will fall unless one of the other variables compensates for this reduction. Similarly, an increase in one of the components, say government spending, would result in an increase in the circular flow of income.

Summary

The circular flow model is a simple way of showing how goods and services are exchanged for money in an economy.