What Is the 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.
Key Takeaways
- The circular flow model demonstrates how money moves from producers to households and back again in an endless loop.
- In an economy, money moves from producers to workers as wages and then back from workers to producers as workers spend money on products and services.
- The models can be made more complex to include additions to the money supply, like exports, and leakages from the money supply, like imports.
- When all of these factors are totaled, the result is a nation's gross domestic product (GDP) or the national income.
- Analyzing the circular flow model and its current impact on GDP can help governments and central banks adjust monetary and fiscal policy to improve an economy.
Understanding the Circular Flow 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.Sectors of a Circular Flow Model
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.Household Sector
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 programs.
Business Sector
In a two-sector model, circular flow models also include the business sector that produces the goods. Businesses absorb a variety of production costs including labor, materials, and overhead. As a result, many companies are able to manufacture products that benefit other parties.
Government Sector
In a three-sector model, government sector cash flows are included. The government injects money into the circle through government spending (G) on programs such as Social Security and the National Park Service. It also extracts money from households and businesses by way of taxes.
Foreign Sector
In a four-sector model, money also flows into the circle through exports (X), which bring in cash from international buyers from the foreign sector. By extension, this indicates that the two-sector or three-sector models are domestic activity only. The foreign sector is different from the domestic sector as there may be administrative inefficiencies that result in lost cash flow due to import taxes, duties, or fees.
Financial Sector
In a five-sector model, cash flow from the financial sector is added. This includes banks and other institutes that provide cash flow via lending services. Some circular flow models also outline investor activity, as cashflow from entrepreneurs and investors may represent an inflow to businesses while net profits from the company represent an outflow.
Circular Flow Model: Injections and Leakages
Just as money is injected into the economy, money is withdrawn or leaked through various means as well. Taxes (T) imposed by the government reduce the flow of income. Money paid to foreign companies for imports (M) also constitutes a leakage. Savings (S) by businesses that otherwise would have been put to use are a decrease in the circular flow of an economy’s income.
A government calculates its gross national income by tracking all of these injections into the circular flow of income and the withdrawals from it. The circular flow of income for a nation is said to be balanced when leakage equal injections. That is:- The level of injections is the sum of government spending (G), exports (X), and investments (I).
- The level of leakage or withdrawals is the sum of taxation (T), imports (M), and savings (S).
Calculating Gross Domestic Product (GDP)
GDP is calculated as consumer spending plus government spending plus business investment plus the sum of exports minus imports. It is represented as GDP = C + G + I + (X – M). If businesses decided to produce less, it would lead to a reduction in household spending and cause a decrease in GDP. Or, if households decided to spend less, it would lead to a reduction in business production, also causing a decrease in GDP.GDP is often an indicator of the financial health of an economy. A common, though not official, definition of a recession is two consecutive quarters of declining GDP. When this happens, governments and central banks adjust fiscal and monetary policy to boost growth.
Keynesian economics, for example, believes that spending leads to economic growth, so a central bank might cut interest rates, making money cheaper, so that individuals will buy more goods, such as houses and cars, increasing overall spending. As consumer spending increases, companies increase output and hire more workers to meet the increase in demand. The increase in employed people means more wages and, therefore, more people spending in the economy, leading producers to increase output again, continuing the cycle.
$25.7 Trillion
The United States GDP as of Q3 2022.