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.
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Watch Now: How Does the Circular Flow Model Work?

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.

The circular flow model starts with the household sector that engages in consumption spending (C) and the business sector that produces the goods.

Two more sectors are also included in the circular flow of income: the government sector and the foreign trade sector. The government injects money into the circle through government spending (G) on programs such as Social Security and the National Park Service. Money also flows into the circle through exports (X), which bring in cash from foreign buyers.

In addition, businesses that invest (I) money to purchase capital stocks contribute to the flow of money into the economy.

Outflows of Cash

Just as money is injected into the economy, money is withdrawn or leaked through various means as well.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.

Adding Up the Factors

The circular flow of income for a nation is said to be balanced when withdrawals 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).

When G + X + I is greater than T + M + S, the level of national income (GDP) will increase. When the total leakage is greater than the total injected into the circular flow, national income will decrease.

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. The standard 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.