What Does the Circular Flow Model Illustrate

What is circular flow model in economics?
In this article, you will learn all about the model of circular flow and why it is important to the economy.

What Does the Circular Flow Model Illustrate? Circular Flow Model describes the path of money throughout an economy. In today’s society, there is a seemingly non-stop transfer of currency on a daily basis. This covers the path of goods from producers to consumers and households, for the exchange of money.

A thing to note is that the rate at which products flow is never at a stable rate all the time. Over time the rate changes along with the state of the economy. The rate fluctuates with heavy dependence on the state of the economy. When the economy is prosperous and strong, there is likely to be a high rate of flow for goods and services. The opposite occurs during times of economic recession. During these times there is a low rate of flow for goods in order to match the lack of flowing money and resources.

Another thing that occurs when it comes to this model leakage. In this case, the leakages that may occur are taxes that are induced by the government, this drastically alters the amount of currency in circulation for the purchase of products and services. Similarly, money that is paid towards other countries also subdues the path of money in a given economy.

What role does money play in the circular flow model?
Money is the medium of exchange that is recognized by both consumers and producers and allows exchanges between households and firms. Money has an important role because money moves from producers to households and back again in an endless loop.

Basics of the Circular Flow Model

This model is comprised of two main aspects, goods and services and factors of production.

What does the circular flow model show

The most common form of circular flow model shows the circular flow of income between the household sector and the business sector.

A market for goods and services

A market for goods and services depends on the fact that consumers from households will purchase finished products from companies. The money will flow from the consumer household to the company in exchange for a finished product.

A market for factors of production

The thing about this model that it is not complete without bringing in the factors that makeup production. Without factoring in these factors to the model then firms should theoretically possess all the currency in the world and households would possess an endless supply of finished products. This is not the case and the things that makeup production must be included. These factors for production are detrimental to goods and services. In the factors market, both households and companies play a vastly different role. The roles almost reverse here as for instance household consumers are the labor force actually producing products. These laborers are then paid a wage by companies in exchange for their hard work in manufacturing finished products. In this case, the consumer households are considered the sellers, and companies are the buyers. This is opposite to a market for products and services since in this case, the buyers are the companies, rather than household consumers.

A combination of goods and services

The model of the circular flow does not include the government. This closed-loop leads towards continued economic activity and prosperity. The fact that there is a lack of the government from within the chain results in a simplified circular flow model.

Although the base circular flow model does not include the government, it can, however, be extended for the inclusion of the government. The government can be added between household consumers and companies to impose taxes upon both parties. The government can also induce taxes on the factors of the production market to implement taxes the money that laborers earn.

The assumptions that must be made for this model

A large assumption when it comes to this model is that sectors are composed of a large number of consumers who will purchase finished products to fulfill their necessities and wants. The household consumers in this situation are the ones who have disposable income which society expects to spend money on these goods to satisfy their desires. In some cases, the assumption is made that households spend the entirety of funds on products and services.

Similarly, this model also includes the business sectors. The business sector is comprised of companies that produced products to match the market demand of consumers for certain goods and services.

Finally, the government also plays a critical role. The government has agencies ranging from the state level nationwide. They are responsible for passing legislation which entails the orderly function of the market. They are also responsible for the taxation of generated income.

Now you know exactly what the model of the circular flow is an how it contributes to society.



Igor has been a trader since 2007. Currently, Igor works for several prop trading companies. He is an expert in financial niche, long-term trading, and weekly technical levels. The primary field of Igor's research is the application of machine learning in algorithmic trading. Education: Computer Engineering and Ph.D. in machine learning. Igor regularly publishes trading-related videos on the Fxigor Youtube channel. To contact Igor write on: igor@forex.in.rs

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