The Circular flow describes how a market economy works. A market economy is one in which individuals influence directly what is produced, marketed, and consumed. Individuals do this by spending money on what they want. This then directs producers to produce goods and services that individuals will consume. The amount of goods and services that are made available is related to the laws of supply and demand.

Example Of Circular Flow Diagram
Circular Flow Diagram Gdp
Circular Flow Diagram Water Pollution
Economic Circular Flow Diagram

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The circular diagram essentially displays the relationship of resources and money between firms and households. The basic circular diagram consists of two sectors that determine income, expenditure, and output: flows of physical things (goods or labor) and flows of money (what pays for physical things). This is the basic circular flow diagram. 5 Factors Not in the Circular Flow Model While the basic circular flow matrix explains supply and demand in a simplistic economic vacuum, this model doesn’t take into account these other key factors of economic systems. Free circular process charts and diagrams for PowerPoint and Google Slides. Cycle diagram templates to show a series of events or steps in a circular flow. Camera Shutter with 8 Parts for PowerPoint and Google Slides.

The circular flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms. It illustrates the interdependence of the “flows,” or activities, that occur in the economy, such as the production of goods and services (or the “output” of the economy) and the income generated from that production. The circular flow also illustrates the equality between the income earned from production and the value of goods and services produced.

The flow of inputs and outputs

Households provide the factors of production (labor, land, and capital) to the firms through the markets for factors of production. The firms will then use these factors of production to produce goods and services to be sold in the markets for goods and services. The households will then buy these goods and services from the firms through the market for goods and services.

The flow of dollars

Firms pay wages, rent, and profit to the households for their supply of the factors of production in the market for factors of production. Households will use this income to spend on goods and services supplied by the firms in the market for goods and services. When households spend money on these goods and services, firms will earn a revenue which can then be reinvested to obtain more factors of production.

Circular Flow Diagram Example – Income and Spending

This circular flow diagram shows an expansive circular-flow diagram for the U.S. economy, with arrows pointing in the direction that money flows. To facilitate reference, letter labels have been placed on certain arrows of the diagram.

The circular-flow diagram (or circular-flow model) is a graphical representation of the flows of goods and money between two distinct parts of the economy:

-market for goods and services, where households purchase goods and services from firms in exchange for money;

-market for factors of production (such as labour or capital), where firms purchase factors of production from households in exchange for money.

Example Of Circular Flow Diagram

The market for goods and services is the place where households spend their money buying goods and services produced by firms. In other words, is the place where firms sell the goods and services they have produced, receiving a revenue paid by households.

This market represents the place where money and goods are exchanged. In this case, the flow of money (green arrow in the diagram below) goes from households to firms, in exchange for finished products, which flow from firms to households (red arrow).

The market for factors of production is the place where households offer their labour, capital and other factors such as land, receiving an income for their use. Firms use these factors in their production.

Circular Flow Diagram Gdp

In this case, money flows from firms to households (green arrow in the diagram below) in the form of wages in exchange for labour, interests for capital and rent for the use of land. Factors of production flow form households (red arrow) to firms, so they can produce more goods and services.

Circular Flow Diagram Water Pollution

When we combine both diagrams, we get the circular-flow diagram, as shown below. The exchanges made in the economy imply a redistribution of rent according to the diagram, and the creation of value makes the economy grow.

It’s worth mentioning that, as usually, diagrams do not shown how the economy actually works. There are a few things that are not showed in this diagram that must be taken into account to really understand how the economy of a country works. For instance, take government intervention. Things such as government spending (in the form of unemployment benefits, for example) or government income (taxes) are not shown in the diagram.

Economic Circular Flow Diagram

However, this diagram introduces a clear view of how the economy works. The way of measuring all these flows of money is the gross domestic product (GDP). It can be estimated using one of three methods: looking at total expenditure, at total income or using the production approach.