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 are markets like labour markets.
- Product markets are the production of goods like cars
Therefore, this is the very basic circular flow of income.
Government tax and spending
- To this circular flow, you could add a government which collects taxes from firms and households.
- The government then spends this 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
Also, we don’t spend all the money we receive, but will save some in banks. Firms could borrow from banks to invest.