The 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.
The circular flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms. It illustrates the interdependence of the “flows,” or activities, that occur in the economy, such as the production of goods and services (or the “output” of the economy) and the income generated from that production. The circular flow also illustrates the equality between the income earned from production and the value of goods and services produced.
The flow of inputs and outputs
Households provide the factors of production (labor, land, and capital) to the firms through the markets for factors of production. The firms will then use these factors of production to produce goods and services to be sold in the markets for goods and services. The households will then buy these goods and services from the firms through the market for goods and services.
The flow of dollars
Firms pay wages, rent, and profit to the households for their supply of the factors of production in the market for factors of production. Households will use this income to spend on goods and services supplied by the firms in the market for goods and services. When households spend money on these goods and services, firms will earn a revenue which can then be reinvested to obtain more factors of production.
Circular Flow Diagram Example – Income and Spending
This circular flow diagram shows an expansive circular-flow diagram for the U.S. economy, with arrows pointing in the direction that money flows. To facilitate reference, letter labels have been placed on certain arrows of the diagram.