Circular Flow Model Definition and Calculation

Circular Flow Model

Investopedia / Alex Dos Diaz

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.

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. 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.

Circular flow model

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.

A change in one sector may critically change the rest of the circular flow model. For example, imagine if governments doubled individual tax rates. This change would likely have major repercussions on business, individuals, and other sectors within the circular flow model.

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).

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. As long as a country's injections is greater than its leakages, a country's economy can theoretically remain sustaining forever. However, if there are cash flow shortages (i.e. leakages), the country must find additional cash flow to compensate for the shortage.

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.

Example of Circular Flow Model

Consider a circular flow model involving Apple employees and Apple product consumers. In this example, we'll also include the government to form a three-sector circular flow model.

From the household/consumer perspective, there are several factors to consider. First, households may spend money and in return, the households get new innovative technology products. Second, households may be employed by Apple. Households may contribute labor hours and time to the company resulting in Apple growing and becoming a more successful company. Households receive income from Apple, though part of these funds is given to the government via taxes. Households then benefit from government programs.

From the business perspective, the company exists to create products. From above, they sell products and take money from households. They also take time for workers to make those products. A certain portion of the company's profits is given to the government in the form of taxes. In some cases, Apple may benefit from government programs or subsidies, so part of these tax dollars may indirectly benefit Apple.

From the government's perspective, both households and business pay taxes. These dollars are then used to deploy capital projects or public programming, both of which may benefit Apple, its employees, or its customers.

In this example, additional sectors (or additional flows) could be added. For example, Apple is an international company that sells goods around the world. Another example is how investors may contribute money into Apple in return for a portion of the company. This example highlights the complexity of the circular flow model as inputs and outputs are continually cycling throughout a systematic economy.

What Is the Outcome of a Circular Flow Model?

A circular flow model doesn't necessarily end or have an outcome. Instead, it describes the current position of an economy regarding how its inflows and outflows are used. This information can be used to make changes about the economy. For example, if a country realizes it has deficient national income, it may choose to reduce its imports and scale back certain government programs.

Why Is It Called a Circular Flow Model?

The economy often moves in a circle as money flows from one sector to another. Households spend money and businesses use that money to create new, better products for the households to buy in the future. Meanwhile, the businesses pay households for their time in helping develop those products. After adding in governments, investors, and foreign markets, the circular flow model depicts how cashflow moves money from one sector to the next in a systematic, organized way.

What Are the Limitations of a Circular Flow Model?

A circular flow model depicts where an economy is now. However, it fails to clearly communicate how a change in one variable may impact all other flows. For example, economists may struggle in determining how a 5% increase in unemployment may impact the circular flow model. Though it's understood that reduced income may lead to less consumption and less tax revenue, a circular flow model may not explain how one change will numerically change other values.

The Bottom Line

Our global economy is incredibly interconnected, and this is often graphically depicted using the circular flow model. The circular flow model details how resources flow into and out of households, businesses, governments, investors, markets, and foreign entities. This cycle shows how the resources of one sector are used to develop others in a cyclical manner.

Article Sources
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  1. Bureau of Economic Analysis. "Recession."

  2. Federal Reserve Bank of St. Louis. "Gross Domestic Product."

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