Circular Flow Model

Basic relationships between households, firms and the government can be illustrated through
circular flow model of economic activity within a market economy and it includes households,
businesses and governments. In the circular flow of the economy, money is used to purchase
goods and services. Goods and services flow through the economy in one direction while money
flows in the opposite direction. Vital purpose behind the model is stability between injections
and leakages in any economy. Investment, government purchases and exports are indulged in
Injections, while leakages include savings, taxes and imports.

Short Cycle with Diagrammatic Representation

People in households buy goods and services from businesses in an attempt to satisfy their
unlimited needs and wants. Households also sell their labor, land, and capital in exchange for
income that they use to buy goods and services that firms produce. Businesses sell goods and
services to households, earning revenue and generating profits. Businesses also pay wages,
interest and profits to households in return for the use of their factors of
production. Governments levy taxes on households and businesses in order to provide certain
benefits to everyone. Savings leaks out to borrowers as it goes through the banking system, and
borrowers use the money to buy goods and services, which then injects the money back into the
circular flow. Government taxes leak out of the circular flow model, and then government
spending injects them back into the economy. Imports leak out of the economy because the
money in our country that's used to buy imports from other countries goes out of our economy
and into their hands. Exports, on the other hand, are an injection because we earn income from
the goods and services we export to other countries.
Households
Households are the primary decision makers because they provide factors of production (labour,
land and capital) to firms in addition to creating demand for the finished products produced by
firms for the market economy. The primary economic function of households is to supply
domestic firms with needed factors of production - land, human capital, real capital and
enterprise. The factors are supplied by factor owners in return for a reward. Land is supplied by
landowners, human capital by labour, real capital by capital owners (capitalists) and enterprise is
provided by entrepreneurs. Entrepreneurs combine the other three factors, and bear the risks
associated with production.

Firms
The function of firms is to supply private goods and services to domestic households and firms,
and to households and firms abroad. To do this they use factors and pay for their services.
Factor of incomes

Factors of production earn an income which contributes to national income. Land receives rent,
human capital receives a wage, real capital receives a rate of return, and enterprise receives a
profit. Members of households pay for goods and services they consume with the income they
receive from selling their factor in the relevant market.

The upper half of the diagram represents the resource market: the place where resources or the
services of resource suppliers are bought and sold. In the sources market, households sell
resources and businesses purchases them. Households (that is, people) own all resources either
directly as workers or entrepreneurs or indirectly through their ownership (through stocks) of
business corporations. They sell their resources to businesses, which buy them because they are
necessary for producing goods and services. The money that businesses pay for resources are
costs to businesses but are flows of wage, rent, interest, and profit income to the households.
Resources therefore flow from households to businesses, and money flows from businesses to
households.
Next consider the lower part of the diagram that represents the product market: the place where
goods and services produced by businesses are bought and sold. In the product market,
businesses combine the resources they have obtained to produce and sell goods and services.
Households use the income they have received from the sale of resources to buy goods and
services. The monetary flow of consumer spending on goods and services yields sales revenues
for businesses.
The circular flow model shows the interrelated web of decision making and economic activity
involving businesses and households. Businesses and households are both buyers and sellers.
Businesses buy resources and sell products. Households buy products and sell resources. There is
a counterclockwise real flow of resources and finished goods and services, and a clockwise
Money flow of income and consumption expenditures. These flows are simultaneous and
repetitive

Flow of income

Income (Y) in an economy flows from one part to another whenever a transaction takes place.
New spending (C) generates new income (Y), which generates further new spending (C), and
further new income (Y), and so on. Spending and income continue to circulate around the macro
economy in what is referred to as the circular flow of income.
Savings and investment

The simple circular flow is, therefore, adjusted to take into account withdrawals and injections.
Households may choose to save (S) some of their income (Y) rather than spend it (C), and this
reduces the circular flow of income. Marginal decisions to save reduce the flow of income in the
economy because saving is a withdrawal out of the circular flow. However, firms also purchase
capital goods, such as machinery, from other firms, and this spending is an injection into the
circular flow. This process, called investment (I), occurs because existing machinery wears out
and because firms may wish to increase their capacity to produce.

The public sector

In a mixed economy with a government, the simple model must be adjusted to include the public
sector. Therefore, as well as save, households are also likely to pay taxes (T) to the government
(G), and further income is withdrawn out of the circular flow of income. Government injects
income back into the economy by spending (G) on public and merit goods like defense and
policing, education, and healthcare, and also on support for the poor and those unable to work.
International trade

Finally, the model must be adjusted to include international trade. Countries that trade are called
open economies, the households of an open economy will spend some of their income on goods
from abroad, called imports (M), and this is withdrawn from the circular flow. Foreign
consumers and firms will, however, also wish to buy domestic products, called exports (X), and
this is an injection into the circular flow.