Circular flow describes how a market economy works. A market economy is one in which individuals influence directly what is produced, marketed, and consumed. Individuals do this by spending money on what they want. This then directs producers to produce goods and services that individuals will consume. The amount of goods and services that are made available is related to the laws of supply and demand.
A model that best depicts how goods and services flow in exchange for money is called the circular flow model, shown in Figure 1.
The primary participants in the circular flow of goods and services are businesses and households. Households are made up of individuals who both spend money and are the recipients of money. Businesses do the same—they spend money and also receive money from households. It is important to note that the flow of goods and services is in one direction in Figure 1, while the flow of money expenditures is in the opposite direction. Both flows make a complete circle—hence, it is called the circular flow of goods and service.
There are two types of markets in the circular flow of goods and services. The resource market is where businesses purchase what they use to produce goods and services. Resources are in the form of labor, natural resources, capital, and entrepreneurship, all of which are supplied by households.
If, for example, a business wants to build a small plant to produce electronic equipment, it must have land on which to build the plant. In the process of building the plant, it uses human laborers who in turn use natural resources to construct the building. Capital to complete the building comes ultimately from households, usually by means of some type of financial institution that lends money to the entrepreneurs (who also come from households) to construct the electronics plant.
Product markets are where goods and services are sold. In the case of the plant that produces electronic equipment, the outlets for its products might be retail stores. Members of households purchase the equipment for their own use in the household. Pieces of electronic equipment are purchased by the households that also provided the resources that made it possible to build the product. The outside circle of the process shown in Figure 1 has been completed.
In the reverse direction is the flow of spending. Beginning with households, the individuals therein spend money for the purchase of goods and services that are provided by businesses. In our example, the purchase is of a finished piece of electronic equipment. The money that is spent on the equipment flows from households to the business, making it possible for the business to sustain operations.
To sustain operations, the business must pay workers and purchase resources. Money continues to flow through the business into the resource markets. Bear in mind that one of the vital resources for the operation of a business is human resources, which are supplied by households. Some of the money that passes through the business goes back into the households as pay for the use of the human resources. Once again, the circular flow is complete: money that came from households through the purchase of electronic equipment passes back to households in the form of wages.
The money flow is more extensive than just wages, as shown in Figure 1. Households do not spend all their wages on goods and services. Some of the money goes into banks, financial investments, real estate, and numerous other places. From those resources, households expect to receive interest or rent as the resource is used. Banks and other financial institutions do not simply hold the money that is deposited by the households—instead, they use it to provide capital for building electronic plants and for numerous other reasons. The money flows back and forth through the circle.
The two flows of income and expenditures are equal. Expenditures on products are ultimately someone's household income. Income that flows into households is expended in some way, either for goods and services or to
purchase stock in companies, CDs, land, or another type of investment.
The circular flow model is an accepted way to show the flow of goods and services in a market economy. In a mixed economy, the government plays an important role as well, but this is not shown in the circular flow model. Local, state, and federal governments also produce, or cause the production of, goods and services. Schools, highways, water-treatment plants, parks, and other facilities are examples of government spending. Governments take part of household incomes in the form of taxes, but they also inject money back into households in the form of wages. Some of that money goes back to the government in the form of taxes and still more goes into other places.
The government has considerable control over the economy, which in turn affects production, employment, and economic growth. If interest rates go up, households will purchase fewer goods and services. If interest rates go down, households will spend more. This spending adds to or takes away from businesses' operations and the amount of goods and services being produced.
Governments can influence the mix of goods and services offered to households. Good examples, although they might seem rather extreme, are when the government ordered the breakup of the Bell Telephone System and later of Microsoft Corporation because it was determined that they violated antitrust legislation and had become monopolies. This kind of breakup affects business operations and households.
The model that is shown in Figure 1 could also be influenced by pricing factors—that is, the laws of supply and demand. The model does not take into consideration changes in prices or how prices are determined, nor does it take into consideration how businesses choose the products or services they produce and market.
Another limitation of this model is that not all the products and services offered by businesses go to the households that provide the resources. For example, some of the electronic equipment produced in the plant described earlier might be exported to another country. In that case, the goods and services leave the circular flow and the resources to pay for the goods and services come from outside the circle. It might be easier to simplify the explanation and include all households and all businesses in the world, but most economists would not agree with that simplification.
While readers should be aware of the influence that government, exporting and importing, and pricing and production has on businesses and households, it is not necessary to alter the circular flow model. It remains a viable illustration of what happens in a macroeconomic sense without microeconomic influences.
It is also considered by some to be a limitation when money leaves the circular flow to be invested in savings, stocks, bonds, and other financial investments. However, the discussion here assumes that the money that is invested does not really leave the circle, but rather is passed on as a resource to others. It is true that some money does leave the circle because banks and other financial institutions are required by law to maintain a certain amount of money on deposit. And because some individuals in households do not trust banks or other financial institutions, they use the coffee can approach to saving their money—they simply keep their savings at home.
The circular flow of goods and services is a simplified illustration of basically two flows: the flow of incomes to households from businesses and the flow of resources to businesses from households. This model excludes the more complex influences of microeconomic factors. In the macroeconomic perspective, resources flow from households to businesses, which change the resources into goods and services for consumption in the product markets. Households are rewarded for the resources they provide in the form of money. It is a circular process that flows in both directions.
see also Economics; Macroeconomics/Microeconomics
Amacher, Ryan C., and Ulbrich, Holley, H. (1995). Principles of Economics (6th ed.). Cincinnati, OH: South-Western Publishing.
Gitman, Lawrence J., and McDaniel, Carl (2005). The Future of Business (5th ed.). Mason, OH: South-Western College Publishing.
McConnell, Campbell R., and Brue, Stanley L. (2005). Economics: Principles, Problems, and Policies (16th ed.). Boston: McGraw-Hill/Irwin.
Roger L. Luft
"Circular Flow." Encyclopedia of Business and Finance, 2nd ed.. . Encyclopedia.com. (October 17, 2018). http://www.encyclopedia.com/finance/finance-and-accounting-magazines/circular-flow
"Circular Flow." Encyclopedia of Business and Finance, 2nd ed.. . Retrieved October 17, 2018 from Encyclopedia.com: http://www.encyclopedia.com/finance/finance-and-accounting-magazines/circular-flow
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