Explaining the Circular Flow Model in Economics

 

What is the circular flow model? 

  The circular flow model is an economic model indicating the flow of money, goods, and services between different sectors of a capitalist economy, which is also known as a free market economy in which prices are based on supply and demand.    In complex modern economies, the circular flow model is also used to follow factors that comprise a country’s gross domestic product (GDP) as well as its gross national income. Hence, the model is also called the circular flow of income model.     

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Emergence of the circular flow model 

  The Irish-born Richard Cantillon (probably born between 1680 and 1690 and died 14 May 1734) was the first economist to present the concept of circular flow. Cantillon was a successful financier and economist who wrote one of the earliest essays on modern economics. Ireland’s History Magazine calls him ‘the father of economics.’    The idea was progressively developed by various economists, including François Quesnay (1694 - 1774), a French economist; Karl Marx (1818 - 1883), the well-known German philosopher and economist; and John Maynard Keynes (1883 - 1946), an economist and journalist from England.   

Basics of the circular flow model explained 

  Analysts consider the circular flow model a valuable tool for comprehending how the economy functions, while it provides a foundation for studies in economics and interconnected sectors.  It is an economic concept of great importance and appropriately named because funds, goods, and services are continuously flowing between economic participants.     In its most basic layout (referred to as the two-sector model), the model indicates that an economy consists of two cycles which flow in opposite directions and in which the two primary participants in the economy are involved, namely individuals/households and businesses/corporations.    One cycle presents the flow of services and goods from businesses/corporations to individuals and households, while individuals provide resources (such as their labour and time) to the businesses for production.     The other cycle (presenting an opposite direction) indicates how money flows from individuals and households to businesses, constituting consumer expenditures on services and manufactured goods and flows back to individuals as personal income (salaries, wages, and dividends, to name a few) for their labour and investments provided.    Both of these cycles are required for an economy to work effectively. Simply put, when individuals buy goods, they pay money for them. When they go to work, they manufacture or produce goods in exchange for money (wages and salaries).     In conclusion, the circular flow model is based on the following assumptions, which are generally based on information obtained from My Accounting Course: 

1. The household sector consists of individuals (consumers) who have money available to spend on goods and services, looking to satisfy their needs and desires. 
2. The business sector comprises all the businesses operating in an economy, such as companies, close corporations, and partnerships, which are able to use their resources (for instance, labour) responsibly and effectively to produce sufficient goods and services. 
3. The households/individuals spend their full income on services and goods, and are not able to save any money. 
4. The way in which goods and services are priced pertains to market mechanisms and not to the circular flow model.  

 

Different types of the circular flow model 

  There are four different types of the circular flow model, namely: the two-sector model, the three-sector model, the four-sector model, and the five-sector model:    

• Two-sector model

As already mentioned, the two-sector model is the most basic model, which comprises only two sectors: households/individuals and businesses. The model is described above under the heading ‘Basics of the circular flow model explained.’  In this model, it is assumed that households/individuals contribute to an economy by giving away time and money and by purchasing the goods and services produced and provided by the business sector. Hence, there are no taxes, investments, or savings included, as is the case with other sectors.  The business sector absorbs numerous production costs such as labour, materials, and overheads (direct and indirect).    

• Three-sector model

In this type of circular flow model, the government sector is added to the two-sector model. In the three-sector model, money flows from households/individuals to the government in the form of taxes.  On the other hand, government expenditures include subsidies, public services, grants, and benefit programs, to name a few. Typically, the government is often the largest buyer of products and equipment, for instance, military equipment.  The government sector consists of all the government institutions on a local, provincial, and national levels.   Notably, the two-sector and three-sector models include only domestic activities.   

• Four-sector model

In the four-sector model, the foreign sector is included in the model. The foreign sector is also referred to as the external sector or the overseas sector.  The foreign sector changes a closed economy (consisting of only domestic activities) into an open economy and is connected to the other three sectors (household/individuals, businesses, and government) via two flows of money: foreign trade (imports and exports of goods and services) and foreign exchange (inflow and outflow of capital, for instance, investments).  The overseas sector differs from the two and three-sector models (domestic sectors) as administrative inefficiencies may cause lost cash flow due to import taxes, duties, or fees.   

• Five-sector model

In the five-sector model, the financial sector is added. It comprises banks and other financial institutions that provide lending and borrowing services to participants in other sectors.  Savings and investments flow from individuals, businesses, and governments to the financial sector, while money flows from the financial sector when banks and financial institutions lend money to households/individuals, businesses, and governments.  The inflows of money into the financial sector equal the outflows of money, making the circular flow of money complete and continuous.  Keep in mind that a change in one sector may significantly change the other sectors of the circular flow model. For instance, if a government raises individual tax rates considerably, this action would likely affect individuals’ consumption spending, which would have a direct impact on the ability of a business to sell goods.     

The significance of the circular flow model 

  The circular flow model is an essential concept in macroeconomics and has been widely used in economic studies, with fundamental impacts on the understanding of economics, including the global economy, which is extremely interconnected.  The following examples listed below indicate the importance and implications of the circular flow model:   

• Knowledge of interrelationship 

The circular flow model illustrates the importance of knowledge of the interrelationship (interdependence) between the different sectors in an economic system. Money flows, and activities require interactions between sectors.   

• Continuous nature of economic activities 

Economic activities are of a continuous nature where money and economic resources flow endlessly in cycles in which the aggregate income and expenditures are in balance.   

• Measurement of Gross Domestic Product (GDP) or Gross National Income (GNI) 

 

• Gross domestic product (GDP) 

The GDP of a country is an approximate calculation (estimate) of the total value of all goods and services produced within the country during a given period, typically a quarter or a year.  The expenditure approach uses the following formula to calculate GDP:  GDP = C + G + I + (X – M)  Where:  C = Consumer spending  G = Government spending   I = Private domestic investment   (X - M) = Net exports, which are total exports (X) minus total imports (M)  The sectors in the circular flow model are the components to calculate the GDP of a country. For example, if businesses decided to reduce production, it would lead to a decline in the spending of individuals and households, causing a decrease in GDP. Alternatively, if households and individuals decided to spend less, it would lead to a drop in the production of businesses, also causing the GDP to decrease.  Typically, GDP is an indicator of the financial wealth of the economy of a country and is used as a tool to compare a nation’s economic growth in one period with economic growth in a previous period.  A government can use the information obtained from the model to implement changes concerning the country’s economy. It may decide to reduce its imports or to scale back certain government programs.   

• Gross national income (GNI) 

The gross national income (GNI) of a country is calculated by adding the wages, salaries, and property income of the residents of the country earned abroad and at home to its GDP. The GNI also includes net taxes and subsidies receivable from abroad.  When the sectors of the circular flow model are used to calculate the gross national income (GNI), the circular flow model is referred to as the circular flow of income model.   

• Injections and leakages 

Injections in the circular flow model refer to the addition of money to the circular flow of income, such as investments, government expenditure, and payments for exports.  Leakages are the withdrawal of income from the circular flow of income. For example, savings and taxes by individuals/households and businesses, as well as payments for imports.  When injections exceed leakages, a country’s GDP will improve. Contrarily, when the leakages exceed the injections, the gross domestic product will decrease.   

Limitations of the circular flow model 

  Although an essential concept in macroeconomics and widely used, the circular flow model has, amongst others, limitations such as: 

• A circular flow model shows a current picture of an economy. However, it does not clearly indicate how a change in one variable may affect all other flows. For instance, analysts and economists may find it hard to determine how a certain increase in unemployment may influence the circular flow model.  

Although it is understood that a decline in income may subsequently lead to a drop in consumption and less tax revenue for the government, the model may not explain how one change will numerically affect other values in the flows. 

• The model includes businesses that produce only consumer goods and services, but does not include the production of capital goods. 

• Services such as education, health, and security, provided by the government to residents, which directly impact people’s economic lives, are not included in the model. 

• The model assumes that prices of services and goods do exist, but it does not explain how these prices are determined and what impact changes in prices have on the flows.  

• Another limitation of the circular flow model is that not all the services and products provided by businesses go to households/individuals who are the providers of the resources that can be drawn on by the businesses. For example, some of the electronic equipment manufactured by a company may be exported to another country. Similarly, livestock or fruit are produced by mega-farms.    

In these cases, the goods and products leave the circular flow and the money to pay for it comes from outside the circle. 

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