Lesson 4: The Circular Flow Models

Circular Flow Model (Diagram)

a model of the economy that shows the circular flow of expenditures and incomes that result from decision makers’ choices and the way those choices interact to determine what, how, and for whom goods and services are produced. Named this because buying and selling of resources and goods and services creates flows between households and firms in both types of markets.

6 Pieces of Building the Simple Circular Flow Model

• Two parties

  • Households

  • Business/firms

• Two Markets

  • Product (Goods and Services) Market

  • Resource (Factor) market

• Two Flows

  • Real Flow

  • Money Flow

Households

Individuals or groups of people living together (sharing expenses)

Business (firms)

Institutions that organize production of goods and services

Markets

Mechanism/ any arrangement that brings buyers and sellers together and enables them to get info and do business with each other (not necessarily a physical place, just transactions)

Product (Goods & Services) Market

markets in which goods and services are bought and sold

Resource (Factor) Markets

markets in which services of factors of products are bought and sold

Real flow

created by movement of actual items between households and firms— either resources (factors of production) or goods and services (products)

Money flow

payments that flow between households and firms for resources (factors of production) or goods and services (products)

Simple Circular Flow Model for a Free Market Economy

• Limitation: Doesnt show business to business

• Real flows stay together and money flows stay together (separate circles)

• Arrow goes in one direction only

• Money flow must be associated with real flow

Mixed economy: Governments in the Circular Flow

6 Real Flows

1. Factors of Production from Households to Business thru Resource Market

2. Factors of Production from Households to Government thru Resource Market

3. Goods and Services from Business to Households thru Product Market

4. Goods and Services from Business to Government thru Product Market

5. Public Goods from Government to Households (neither market)

6. Public Goods from Government to Business (neither market)

7 Money Flows

1. Consumer Spending by Households thru Product Market

2. Business Spending by Business thru Resource Market

3. Government Spending by Government thru both Resource Market and Product Market

4. Factor Payments (Income) to Households thru Resource Market

5. Revenue (Income) to Business thru Product Market

6. Taxes (Income) to Government by Households and Business (neither market)

7. Transfer Payments/Subsidies by Government to Households and Business (neither market)

Two main ways that Households and firms in US economy interact with households and firms in other economies

1. International trade (buy and sell)

2. International Finance (lend and borrow)

International trade

buy and sell goods and services (and resources). Imports and exports

Imports

Goods and Services bought from firms of other countries

Exports

Goods and Services that we sell to households and firms in other countries (doesnt need to leave country to be consumed (ex. international education)

International Finance

Borrow (at a lowest interest rate, needed when value of imports exceed value of exports) and lend

Circular Flows in the Global Economy

These are all MONEY flows (no REAL flows)