In simplistic terms, the circular flow model describes the mutually beneficial exchange of money between the two most vital parts of an economy: households, firms and how money moves between them. The circular flow model describes money as it moves through various aspects of society in a cyclical process.

Understanding the circular flow model

1. Households – whose primary function is to supply firms with production factors. The 4 factors of production are land, enterprise, real capital, and human capital and each is supplied by factor owners in exchange for a reward. For example, land is supplied by landowners, human capital is supplied by labor, and capital is supplied by capital owners. Entrepreneurs, who absorb enterprise production risks, combine land, human capital, and real capital.
2. Firms – whose primary function is to supply goods and services to households and other firms. This is achieved by paying for the services of the abovementioned factors.

Money moves between households and firms in a cyclical process whenever a transaction takes place. Transactions are attributed to factor incomes. For example, human capital receives a wage in exchange for labor. Land receives rent and real capital receives a rate of return.

Firms also inject money into the circular flow model through production function.

A simple production function (Q) formula argues that output is a function (f) of factor inputs, where Q = f (L, La, K).

Where:

• L = land
• La = labor, and
• K = capital.

Consumer spending in the circular flow model

Another way to think of the circular flow model is by considering income and spending. In this case, money flows in the opposite direction to that of goods and services and production factors.

Here is how it works:

• When a household wants to purchase a good or service, money flows toward the product market. Most understand this process as consumer spending.
• The product market then purchases goods and services from businesses to provide them to households. This generates revenue.
• To manufacture or provide goods and services for the product market, the business must purchase resources from the resource market. This is a cost to the business.
• With resources acquired, the business must pay workers and landowners to create goods and services in the form of income. This income is then used by the household to purchase goods and services, thereby restarting the process.

Other key factors in the circular flow model

Supply and demand rarely occur in a vacuum. Indeed, simplistic circular flow models omit other key drivers of economic systems.

These include:

• Government – an important player because of its ability to inject and remove money from the flow. Government spending can be directed toward the product market (a new highway) and the resource market (teachers, fuel, or electricity). Governments also remove money from the flow (“leakage”) through sales, income, or property taxes.
• Financial institutions – banks also contribute to leakage by encouraging households and businesses to save their money with higher interest rates. They can also inject money into the circular flow model in the form of loans and interest rate cuts.
• Foreign sector – through imports, the foreign sector injects goods but leaks income because goods are manufactured offshore. However, this is at least partially offset by exports, which leak goods but injects income. 

Key takeaways

• In simple terms, the circular flow model illustrates the cyclical flow of money as it moves between households and firms.
• The circular flow model of consumer income and spending moves in the opposite direction to the classic model incorporating goods and services and production factors.
• Many circular flow models omit important players, such as government, banks, and the foreign sector. Each has the ability to inject and remove money or goods and services from the process.

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