Lesson 11: Circular Flow of Economic Activities
Lesson objective
At the end of this lesson, you will be able to:
- Define circular flow of income.
- Explain the models of circular flow.
- Construct a circular flow of economic activities and interpret them.
Brainstorming Question
What is the circular flow of economic activities?
Key Terms and Concepts
- Circular Flow of income
- circular flow
- Real flows
- Money (financial) flows
- Three-sector circular flow model
A circular flow of income is a visual model of an economy that shows how a currency, such as the Birr, flows through markets among decisionmaking units.
A circular flow is a pictorial representation of the continuous flow of payments and receipts for goods and services and factor services between different sectors of the economy.
Real flows refer to the physical movement of goods and services between different sectors of an economy, such as the flow of raw materials, finished products, and labor.
Money (financial) flows refer to the movement of funds between different entities in an economy
In the three-sector circular flow model, the economy has three sectors: households; firms; and government.
Circular Flow of Economic Activities
The circular flow of economic activities is a simplified macroeconomic model that provides an overview of how different sectors of the economy – households, businesses, and the government – interact through the exchange of goods and services, productive resources (factors of production), and money.
Production, exchange, and consumption are three important activities of an economy. As people carry out these economic activities, transactions between different sectors of the economy occur. Because of these transactions, income and expenditure move in a circular way in an economy. This is called the “circular flow of income” or “circular flow diagram.” Before we illustrate and explain the circular flow of income in an economy, let’s consider the different sectors into which an economy is divided for this purpose. These sectors are also sometimes known as decision-making units of the economy. Generally, they are called “economic agents.”
Definition: A circular flow of income is a visual model of an economy that shows how a currency, such as the Birr, flows through markets among decision-making units.
Circular flows of income and expenditure
A circular flow is a pictorial representation of the continuous flow of payments and receipts for goods and services and factor services between different sectors of the economy. It also refers to the process whereby the income and expenditure of an economy flow in a circular manner continuously through time.
Types of flows
Economic transactions, like the sale and purchase of goods and factor services, generate two types of flows, namely, real flows and money flows. Both refer to exchanges of goods and services for money, but the two concepts differ in how they refer to the opposite sides of these exchanges as they relate to individuals and companies.
Note that real flows and money flows are two sides of the same coin. A real flow of goods and services is matched by an equal but opposite money flow.
Real flows
real flows consist of the flows of
- factor services from the owners of factor services to the producers, and
- goods and services are passed from the producers to the buyers.
Money (financial) flows
money flows consist of the flows of
- money earned from factor services such as rent, wages, interest, and so on; and
- the money expenditures incurred for the purchase of goods and services.
Households provide factors of production and services to businesses, receiving wages, rent, interest, and profits in exchange. Households use this money to buy goods and services from businesses. Businesses use the money from selling to households to compensate them for the factors provided, completing the circular flow of money between the two sectors.
Figure 3.1 Circular flow of income: Real flow and money flow
Models of circular flow
For closed economies, we have two types of circular flow models:
- a two-sector model, consisting of the flows between households and business firms,
- three-sector model, consisting of the flows among households, business firms, and the government sector.
Two-sector circular flow model
The two-sector model represents a private, closed economy with only two sectors, namely, the household sector and the business sector (firms).
In this model, the underlying assumptions are:
- There are only two sectors in the economy: the household sector and business firms.
- Household sectors are owners of factors of production, and they supply factor services to firms.
- Firms produce goods and services and sell their entire output to households.
- Households receive income for their factor services and spend the entire amount on consumption.
- There is no saving in the economy.
- There is no government sector.
- It is a closed economy, and therefore, there are no exports or imports.
The circular flow in a two-sector economy is illustrated in the figure below.
The circular flow model illustrates the continuous exchange between households and firms, comprising two main flows: the real flow and the money flow. The real flow involves households providing factor services (land, labor, capital, entrepreneurship) to firms, which use these to produce goods and services consumed by households. Concurrently, the money flow depicts firms paying households for these factor services, and households spending this income on goods and services from firms. This cyclical interaction highlights the economy’s interdependence, with the total income of households equating to the total receipts of firms.
Figure 3.2: Circular flow of income in a two-sector economy
Three-sector circular flow model
In the three-sector circular flow model, the economy has three sectors: households; firms; and government. In this model, the activities of the government (and those of the other two sectors) influence the flow of income. Government economic activities are divided into two categories: government revenue and government expenditure. The circular flow of income in a three-sector economy is shown in the figure below.
The circular flow model illustrates the interactions among households, firms, and the government within an economy. Firms pay households for factor services (land, labor, capital, entrepreneurship), while households spend this income on goods and services from firms. Households save a portion of their income, which is deposited in the capital market and subsequently used by firms for investment. The government generates revenue through taxes on both households and firms, which it redistributes by purchasing goods and services, providing subsidies to firms, and making transfer payments to households. This interconnected flow of money ensures a continuous circulation of national income among the three sectors.
Figure 3.3: Circular flow of income in a three-sector economy