The circular flow of income

The circular flow of income is a macro-econmoic model of economic behavior. It can be considered on a number of different levels, depending on the type of economy.There are two main groups to be considered:-

• Households - Owners of wealth of the nation. They also own the factors of production and will supply them to firms for rewards (rents, wages, interest and profits)


• Firms - Produce goods and services using factors of production hired from households.

In a subsistence economy, there is no trade as individuals produce entirely for themselves and their families - i.e. the household is the firm.

In the slightly more complicated closed economy model, firms pay households for factors of production and households pay firms for goods and services.

                   \
    ----------------               --------------
   |               /   HOUSEHOLDS  /             |
   |           -----               ------        |
   |          |                    \     |       |
 Rent        land                    goods     expenditure  
 Wages       labour                  services  on goods
 Interest    capital                     |     and
 Profit       |                          |     services
   |          |                          |       |
   |          |      \                   |       |
   |          --------         ----------        |
   |                 /  FIRMS  /                 |
    ------------------         ------------------
                               \

This model shows the transfer of money within an economy, however it assumes that all the money of a household is spent on domestic goods. This is of course untrue. There are imports, taxes and savings. These are called leakages. However, they are balanced by their respective injections - exports, government spending and investment.