Circular Flow of Economic Activity

Readers Question I am having trouble understanding the circular flow of economics. Could you explain it in simple terms, like how is it involved in my life, I don’t get the connection to the product and factor markets

The circular flow of income is a simple model to explain basic economic transactions.

To start off, consider 2 groups of people

  • Households – people like yourself
  • Firms – companies like BMW, Vodafone e.t.c.

Householders (people like you or me) could get a job in a factory making cars. This leads to an output of goods.
In return workers get income (wages) from the firm.
With this income we can buy the goods firms are producing. This is Expenditure.

Thus in a closed economy with no saving, tax or imports. Total Output should be the same as Total Income and Total Expenditure.

  • Note: Factor markets is markets like labour markets.
  • Product markets are the production of goods like cars

Therefore, this is the very basic circular flow of income.

To this circular flow you could add a government which collects taxes from firms and households and spends money in the form of benefits and subsidies.

Also you could add a foreign dimension.

  • Goods and services could be exported – Money comes into economy
  • Goods and services could be imported – Money leaves the economy

Diagram to Show Circular Flow of Income

Circular Flow

Circular Flow

Also, we don’t spend all the money we receive, but will save some in banks. Firms could borrow from banks to invest.

7 Responses to Circular Flow of Economic Activity

  1. Joseph September 15, 2009 at 7:50 pm #

    You cycle omits the accumulation of capital, which means that income does not equal expenditure.

    Becasue of this inequality inceasing levels of debt/leverage are require to maintain household income and make income equal to expenditure

    put it simply: capital accumulation implies credit bubbles

  2. ruchi October 18, 2009 at 12:07 pm #

    that was really a very good way to teach circular flow

    • Rea March 8, 2012 at 5:21 pm #

      I think da diagram is ok

  3. adeola bukky yemisi December 10, 2009 at 3:21 pm #

    perfect lecture even an ordinary person will understand what we mean by circular flow of income you are my role model i which i can lecture like that

  4. mrinal sony September 6, 2012 at 3:55 pm #

    Really nice, dude. Like i tried to read from the professor’s notes, i couldn’t understand it very clearly. You gave a clear picture. thumbs up. :)

  5. Snethemba P. Zungu February 22, 2013 at 1:31 pm #

    Thanks now I know it,,,I dont jst understand it better but I know it…surely I can explain 2 others..u r a star thank you tons

  6. rose July 22, 2013 at 11:07 am #

    really nice, very simple and understandable.