Circular Flow Model

An economic model that presents how money, goods, and services move between sectors in an economic system

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Written by CFI Team

What is the Circular Flow Model?

The circular flow model is an economic model that presents how money, goods, and services move between sectors in an economic system. The flows of money between the sectors are also tracked to measure a country’s national income or GDP, so the model is also known as the circular flow of income.

Circular Flow Model - Diagram

Summary

The circular flow model, also known as the circular flow of income, describes how money and economic resources flow in cycles between different sectors in an economic system.
In the basic (two-factor) circular flow model, money flows from households to businesses as consumer expenditures in exchange for goods and services produced by the businesses, then flows back from businesses to households for the labor that individuals provide.
The five-sector model consists of (i) households (the public sector), (ii) businesses, (iii) government, (iv) the foreign sector, and (v) the financial sector.

Understanding the Circular Flow Model

The idea of circular flow was first introduced by economist Richard Cantillon in the 18^th century and then progressively developed by Quesnay, Marx, Keynes, and many other economists. It is one of the most basic concepts in macroeconomics.

How an economy runs can be simplified as two cycles flowing in opposite directions. One is goods and services flowing from businesses to individuals, and individuals provide resources for production (labor force) back to the businesses.

In the other direction, money flows from individuals to businesses as consumer expenditures on goods and services and flows back to individuals as personal income (wages, dividends, etc.) for the labor force provided. This is the most basic circular flow model of an economy. In reality, there are more parties participating in a more complex structure of circular flows.

Circular Flow Models with Sectors

Two-Sector Model

The model described above is the two-sector model, which is the most basic model containing only two sectors: individuals or households and businesses. In the two-sector model, it is assumed that households spend all their incomes as consumer expenditures and purchase the goods and services produced by businesses. Thus, there are no taxes, savings, or investments that are associated with other sectors.

Three-Sector Model

In the three-sector model, the government is added to the two-sector model. In this model, money flows from households and businesses to the government in the form of taxes. The government pays back in the form of government expenditures through subsidies, benefit programs, public services, etc.

Four-Sector Model

The four-sector model contains the foreign sector, which is also known as the overseas sector or external sector. The overseas sector turns a closed economy into an open economy. It is connected to the other sectors through two flows of money: foreign trade (imports and exports) and foreign exchange (inflow and outflow of capital). Like the other sectors, each flow of money is paired with a flow of a factor of production or goods and services.

Five-Sector Model

The fifth sector – the financial sector – is added to complete the circular flow model. It includes banks and other institutions that provide borrowing and lending services to the other sectors. Savings and investments are assumed in the five-sector model, which flow from other sectors with residual cash into the financial institutions, then out to the sectors that need money. As long as lending (injection) is equal to borrowing (leakage), the circular flow reaches an equilibrium and can continue forever.

Implications of the Circular Flow Model

As a fundamental concept of macroeconomics, the circular flow model has been widely applied in different studies, with significant impacts on the understanding of economics. Four examples are listed below to show the significance of the model.

Measurement of national income: The sectors in the circular flow model are the components of the calculation of national income. The expenditure approach calculates a nation’s GDP as the sum of the household consumption expenditures, private domestic investment, government consumption and investment expenditures, and net exports (GDP = C + I + G + [X-M]).
Knowledge of interdependence: The circular flow model underpins the knowledge of interdependence between sectors in an economic system. The activities and money flows cannot take place without interaction with another sector.
Unending nature of economic activities: Money and economic resources flow in cycles indefinitely with an equilibrium of aggregate income and expenditures.
Injections and leakages: The circular flow of an economy is balanced when the total injections equal the leakages. If injections overweight leakages, the country’s national income will grow. If injections are below leakages, the national income will decrease.

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