The Circular Flow of Income is an economic model which depicts how an economy on a most basic level functions.
We start by observing that two economic agents exist in any economy:
(i) Households- so they own factors of production such as land, labour capital and enterprise and demand goods and services
(ii) Firms – They use factors of production and turn them into goods and services because they seek rewards – which is not only money but recognition etc.
Before we go on, you may be wondering what about government? Other countries we trade with? They are all valid economic agents but the whole point of economics is formulate simple models which allow us to experiment. So the Circular Flow of Income model is based on 3 assumptions;
(1) The economy operates with closed trade which means no international trade exists
(2) No government exists
(3) No economic agent saves, any money received will be spent.
We will see in a short while what actually happens when these assumptions are removed. But for now let me explain how the two economic agents (firms and households) are engaged in this model.
What happens is household they own factors of production which firms demand in order to produce goods and services. So a trade takes place, households sell land for rent; labour for a wage; capital for interests, profits and dividends and finally; enterprise (by which I mean entrepreneurial skill) for recognition and a salary. This is demonstrated by the two arrows shown on the diagram.
On the other end firms sell these goods and services to households in return for a payment which if provides sufficient revenue not only encourages a firm to keep on producing but attracts more firms into the industry.
It is important to note two things. In some place this model is depicted with four stops in the circle firms, households, market for goods and service and market for factors of production. These markets simply denote that a trade is taking place between some form of money and goods and services/factors of production.
The second thing to note is that these arrows are incredibly important when we look at more serious models of the Circular Flow of Income. For example, the goods and services one can denote national output and rent/wage/profit one can denote national income.
So now to make the model more realistic. In reality we know that the three assumptions (no government, international trade and savings) are incorrect albeit at different levels and powers in different countries. But we do know they exist and they come under what we term in economics as leakages and injections. Leakages and Injections are external sources which either bring money in or out an economy.
So injections are external sources whereby money is gained in an economy and there are three of these which can be remembered by the abbreviation GXI – Government Spending, Exports (foreign money) and Investment. Leakages conversely are SMT (senior management team) Savings, Imports and Taxation. They are merely opposites and we can add an additional arrow to show these and make the model more realistic.