What Is The Circular Flow Model in Economics?

This infographic explains the circular flow of products and services

Circular Flow of Products and Services

In ancient times humans were primarily engaged in subsistence farming which meant that they produced goods, mainly food and grain, primarily for their own consumption. Any production surplus was simply swapped with others to meet needs that weren’t met by their own production. As a result, an exchange mechanism evolved where products were simply swapped for others – known as the barter system. Apart from food and grains, people bartered livestock and plant products similar to how we use money today. The markets were social setups where people in a community met and exchanged goods.

As trade grew outside these communities and expanded across villages and even countries, economies grew in complexity. A standard model of exchange was necessary to pace up trade. Another issue stemmed from the fact that it became increasingly difficult to identify the right ratio for the exchange. How many bags of rice was a chicken worth? A combination of these factors led to the birth of money. Metal objects were first introduced as money because of the durability and malleability of metal. The concept of money went through several iterations to become the paper fiat currency that we use today. 

With the advent of money came the ability to create and store value from surplus production. This led to a race to improve production efficiency, bringing about the Industrial Revolution in the 18th and 19th centuries. Economies became even more complex, and mechanization was brought in to improve crop production, mining, manufacturing, and transport. The seeds of the industrial revolution first took root in the United Kingdom but quickly spread through the rest of Europe, North America, and ultimately the whole world.

The pace of change has not declined since the industrial revolution. As a result, the modern economy, as we know it today, has become a jumbled web of transactions between firms, individuals, the government, and foreigners.

Despite the complexity, the basic premise of the economy has remained the same. Thus, the economy is still a marketplace, where parties come together to purchase goods and services. However, the nature of parties has significantly evolved. What started as households (individuals) trading with each other has now expanded its reach to encompass firms, governments, and countries as well.

Firms (or corporations) play an essential role in the economy. First, they consume labor from the household sector (households) in the form of employment and capital in the form of investments. Second, these firms aim to efficiently produce goods and services, which are sold back to the households for consumption. That serendipitous cycle is what economists call the circular flow of products and services.

Let’s illustrate this circular flow with an example. Assume you are setting up a chocolate manufacturing company in Texas. Your company will require land to set up a manufacturing plant, which you decide to buy from an individual (household). It would be best if you then had capital. Not just money but also infrastructure like building, equipment, and inventory management software. Last but not least, you probably need workers (labor) to work in your plant to turn raw materials like milk and cocoa into chocolate.

Let’s assume there are only two parties in the economy to avoid complexity – firms, and households. Households own and provide land, capital, and labor to firms. This arrangement essentially means that firms are buyers of the above three factors and households are sellers. Thus, a market where firms and households come together to buy and sell factors of production is a factors market. 

But that’s only one-half of the economy. The firms cannot be indefinite buyers of factors from households. Therefore, they also manufacture goods and services that they sell to households (In our case, that’s chocolates). 

To summarize, firms buy factors of production from households and put them together to manufacture finished goods which households buy from the firm. This completes the economy’s circular flow of products and services.

In today’s world, such firms are behemoths like Apple Inc. and Google Inc., and households are citizens like us. These big corporations open huge offices around the country, buying or leasing land owned by the natives, putting in the capital of shareholders (households), employing the citizens around the office location, and selling iPhones and each product to those very citizens.

Circular Money Flow / Income Flow

Previously, we discussed the circular flow of products, which was pretty straightforward. First, firms come to the factor market to buy factors of production from households. Then households buy manufactured products and services from firms in the finished goods market.

Buying and selling goods involves paying for supply factors using money which becomes income for the households. Then, households use that income to pay for goods they intend to consume, thereby completing the circular flow of income. But, first, the money goes from the firms to households as firms pay for the factors of production. That’s the income for households. Households then pay for finished products, which becomes income for firms.

The total income earned by the firm from selling products and services to households is the firm’s revenue. The total payout from the firms for factors of production is the cost. The difference between what the firms earn and the payout is the firm’s profit. Firms usually invest this profit in manufacturing more products or distributing the profit as income to households, thereby perpetuating that cycle. 

Here is a circular flow diagram illustrating the circular flow of products, services, and income.

An infographic that explains the history of the circular flow of money/income.

It is interesting to note that the circular flow of money is counter-cyclical to the circular flow of products and services. This is because the total expenditure of one party is equal to the total income of the other party. 

Let’s elaborate on this further. While the income from products and services (revenue), land (rent), and labor (salaries/wages) is easy to define, the income from capital adds a wrinkle of complexity since the income from capital manifests in the form of investment income.  

Let’s find out how.

Role of The Financial Sector (Banks), Firms, and Households in The Circular Flow Model.

We all know that there are other parties in an economy. Parties such as governments and banks. At this point, we are ready to expand our understanding of the circular flow of product and capital to include these other parties.

Let’s get to them one by one starting with financial institutions to clear things up on how capital earns money for households.

Financial Institutions

Financial institutions are intermediaries that primarily act as movers of money. Households don’t immediately spend all the money they earn through factors of production. Instead, they usually save a portion of it for delayed consumption. These savings are usually parked in a financial institution. The financial institution pools savings from a large number of households which is then lent to firms to finance their capital expenses associated with production. The bank charges interest to the firms for using its money and gives a part of that interest to households in exchange for depositing their funds with the bank.

This is how households provide capital to firms and earn interest on that capital, which forms the basis for investment income. Banks also profit from such an arrangement and pay taxes on such profits to the government. So this is a good time to introduce governments into the picture.

Government

Governments are facilitators for firms and households. Be it federal or state, the governments provide services to all the involved parties and get taxes in return. These taxes are used for the common good of citizens, like creating common infrastructure, including railroads, highways, ports, and hospitals. In the United States, the federal government levies income tax, payroll tax, and capital gains tax, and the state governments levy sales and excise taxes.

The government takes a portion of all transactions and income from both the firms and individuals alike. Therefore, a part of household income from land, labor, and capital will be passed to the government as taxes. Similarly, a part of the revenue and profits of firms will be taken away by the government as tax.

Foreign Entities and The Foreign Sector

Infographic ghat explains foreign entities and the external sector

Not all trade that happens in the economy is with parties within the country. For instance, the United States exports more than a trillion-dollar worth of products and services and imports more than two trillion dollars’ worth of products and services from across the world.

Foreign trade and exports inject additional income and capital into the economy, while imports result in money leaving the economy. We’ve already discussed Gross Domestic Product in the past. Let’s extend that understanding of GDP to include how GDP is calculated. 

The GDP Calculation

An infographic that explains how GDP is calculated

GDP is the value of all goods and services produced in an economy. The Bureau of Economic Analysis collates and publishes the GDP in the United States. In 2018, $20.5 trillion worth of goods and services were produced in the U.S.  

Once you understand how an economy functions through the circular flow of products and capital, it will be easy to calculate GDP. GDP can be calculated based on income as well as expenditure approach. 

In the income approach, we add all the income generated by factors of production. This includes rent on land, salaries/wages, interest on capital, and corporate profits. There is a little tweak in this approach as money also goes to the government as indirect taxes like sales tax and property tax. These taxes are not considered in any of the heads of income from factors. In addition to taxes, depreciation of fixed assets like plants & equipment is also added to national income. 

These adjustments make GDP calculation through the income approach a little complex.

Another approach to GDP calculation is the expenditure approach, wherein we add the expenditure made by all the parties in the economy on finished goods and services and factors of production. Since one party’s expense is another party’s income, this approach considers all the transactions in the economy. Moreover, this approach does not require additional adjustments, which makes it simple to calculate.

Under the expenditure approach, GDP is calculated using the following formula:

Household Expenditure on finished goods and service (C) + Capital Investment by firms on factors of production(I) + Government expenditure on goods and services and gross investment (G) + net exports (exports – imports) (NX)

GDP = C + I + G + NX

For clarity, we only take capital investments of firms and not regular expenditures like salaries, wages, rent, and interest. These expenditures are already included in household expenditure (as households will spend out of their incomes from factors). Therefore, counting them in the firm’s expenditure will lead to double counting and overestimation of GDP. On the other hand, capital investments like expenditure on plants, equipment, and software will be counted because they are not included in any other head in the GDP calculation. 

Another point worth noting is that the government spends on finished goods and services and also invests in long-term assets like highways and ports. These expenditures are counted under the expenditure approach as they are also not added under any other head.

Finally, we use exports because that’s the money foreigners spend on our goods and services. We deduct imports because that’s the money locals spend on products and services that are not produced within the country.

If we look at the formula again, it becomes clear that the economy will grow if these four heads of expenditure grow. If for some reason, one of the heads does not grow, others can make up for it. Generally, when households spend less due to lower income growth and firms do not spend due to loss of confidence, the government boosts government spending to inject capital into the economy. When the confidence of households and firms comes back, the government reduces expenditure to balance its finances.

As far as exports and imports are concerned, economies like the U.S. run huge trade deficits because we depend on services for much of our GDP. As a result, firms in the U.S. focus on developing capabilities, know-how, and intellectual property, which are high-end jobs, and outsource the low-end jobs to other countries. We then import finished goods that are made using our know-how from other developing countries. 

The strategy has worked very well for the United States, making the country home to the world’s most innovative businesses and corporations that have become leaders across the world. These firms have created billions of dollars in revenue and profits and trillions of dollars in market capitalizations using this approach.

Sources and additional reading:

The St. Louis fed does an excellent job of breaking down the concept of circular flow and goes into details about the role of government in the circular flow model.

Carleton College has a well-defined teaching model on circular flows that formed the basis for this content.

Khan Academy has a great lesson on circular flows.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.