It dispenses with details that, for some purposes, are significant.Ī more complex and realistic circular-flow model would include, for instance, the roles of government and international trade.

The above circular flow diagram in Figure is one simple model of the economy. Any excess of tax revenue over government spending is called public saving, which can be either positive (a budget surplus) or negative (a budget deficit).

The government receives revenue from taxes and uses it to pay for government purchases. Households receive income and use it to pay taxes to the government to consume goods and services, and to save through the financial markets.įirms receive revenue from the sale of goods and services and use it to pay for the factors of production.īoth households and firms borrow in financial markets to buy investment goods, such as houses and factories. Let’s look at the flow of dollars from the viewpoints of these economic actors. And how dollars ﬂow among them through the various markets in the economy. It shows the linkages among the economic actors-households, ﬁrms, and the government. The image below more accurately reﬂects how real economies function. In either case, the dollar enters the income of some household and, once again, is back in someone’s wallet.Īt that point, the story of the economy’s circular flow starts once again. The dollar doesn’t stay at Starbucks for long, however, because the firm uses it to buy inputs in the markets for the factors of production.įor instance, Starbucks might use the dollar to pay rent to its landlord for the space it occupies or to pay the wages of its workers. When the dollar moves into the Starbucks cash register, it becomes revenue for the firm. There you spend it on your favorite drink. If you want to buy a cup of coffee, you take the dollar to one of the economy’s markets for goods and services, such as your local Starbucks coffee shop. Imagine that the dollar begins at a household, sitting in, say, your wallet. Let’s take a tour of the circular flow by following a dollar bill as it makes its way from person to person through the economy. Hence, spending on goods and services flows from households to firms, and income in the form of wages, rent, and profit flows from firms to households. What’s left is the profit of the firm owners, who themselves are members of households. The firms use some of the revenue from these sales to pay for the factors of production, such as the wages of their workers. The households spend money to buy goods and services from the firms. The outer loop of the circular-flow diagram represents the corresponding flow of dollars. Hence, the factors of production flow from households to firms, and goods and services flow from firms to households. The firms then use these factors to produce goods and services, which in turn are sold to households in the markets for goods and services. The households sell the use of their labor, land, and capital to the firms in the markets for the factors of production. The inner loop of the circular-flow diagram represents the flows of goods and services between households and firms. The circular flow diagram offers a simple way of organizing all the economic transactions that occur between households and firms in the economy. In these markets, households provide firms the inputs that the firms use to produce goods and services. In the markets for the factors of production, households are sellers and firms are buyers. In particular, households buy the output of goods and services that firms produce. In the markets for goods and services, households are buyers and firms are sellers. Households and firms interact in two types of markets. Households own the factors of production and consume all the goods and services that the firms produce. These inputs are called the factors of production. In this model, the economy has two types of decisionmakers-households and firms.įirms produce goods and services using inputs, such as labor, land, and capital (buildings and machines). Above Diagram presents a visual model of the economy, called a circular flow diagram.

Circular flow diagram market