Circular Flow Model of Economy

Circular flow model is the basic economic model and it describes the flow of money and products throughout the economy in a very simplified manner. This model divides the market into two categories −

  • Market of goods and services
  • Market for factor of production

The circular flow diagram displays the relationship of resources and money between firms and households. Every adult individual understands its basic structure from personal experience. Firms employ workers, who spend their income on goods produced by the firms. This money is then used to compensate the workers and buy raw materials to make the goods. This is the basic structure behind the circular flow diagram. Let’s have a look at the following diagram −

Circular Flow Diagram

In the above model, we can see that the firms and the households interact with each other in both product market as well as factor of production market. The product market is the market where all the products by the firms are exchanged and factors of production market is where inputs such as land, labor, capital and resources are exchanged. Households sell their resources to the businesses in the factor market to earn money. The prices of the resources, the businesses purchase are “costs”. Business produces goods utilizing the resources provided by the households, which are then sold in the product market. Households use their incomes to purchase these goods in the product market. In return for the goods, businesses bring in revenue.