Circular Flow of Economic Activity

What It Means

All market economies are characterized by a circular flow of economic activity. This means that money and products (including the products businesses need to operate) move in a circular fashion between businesses and households. This situation is often illustrated using a diagram that allows us to visualize the basic workings of the overall economy.

A market is any place or system allowing buyers and sellers to come together. A market economy is one in which the free interaction of buyers and sellers determines most of the important features of economic life. Most economic decisions in a market economy are based on the forces of supply (the amount of any good or service that a seller is willing to sell at a given price), demand (the amount of any good or service that buyers are willing to buy at a given price), and prices. Sellers tend to supply more and more of their products as prices rise (because they want to maximize their profits), while buyers tend to buy less and less of a product as prices rise (because they want to maximize their own economic well-being). When buyers decide to purchase or not purchase certain goods in certain quantities, sellers make corresponding decisions about what to supply and in what quantities.

The circular flow model illustrates how market forces determine the overall shape of the economy. Businesses and households act as both buyers and sellers in the economy. Businesses sell products to households in exchange for money, and households sell products called the factors of production (land, labor, and capital [money and equipment], the resources required to do business) to businesses. The inner circle of the model shows products and services moving clockwise between businesses and households. The outer circle of the model shows income (money) moving counterclockwise between businesses and households.

This model is a simplification of economic activity, but it allows us to understand some central facts about market economies. Businesses and households are dependent on one another. They are bound to one another by supply and demand relationships that, in being played out, dictate the working of the economy. The money that households use to satisfy their needs and wants comes from businesses, and the money that businesses need in order to operate comes from households. Likewise, the products that households need and want come from businesses, and the factors of production that businesses need in order to operate come from households.

When Did It Begin

The idea that income and goods flow in a circular fashion between businesses and households dates to the earliest economic theorists. An obscure Irish banker named Richard Cantillon (1680–1734) may have been the first to use the concept. Cantillon probably wrote his only surviving work, Essai sur la Nature du Commerce en Général (An Essay on Commerce in General), in the year 1732 or thereabouts, but it was not published until 1755 in France. Cantillon presented the economy as a unified system, comparable to the cosmos, in which the individual elements were interdependent on one another. The Essai directly influenced the Physiocrats, a group of French thinkers led by Francois Quesnay (1694–1774) who further laid the groundwork for the field that would become political economy (the original term for the discipline we now call economics). The Physiocrats’ name was derived from Quesnay’s occupation as the physician for King Louis XIV of France. Quesnay compared the economy to the human body, with money and goods functioning as the blood. In 1758 he drew an early version of the circular flow diagram to explain to the king how resources, money, and goods moved between farmers, landlords, and merchants.

The development of today’s circular flow model is attributed to the American economist Frank Knight (1885–1972). Knight called the diagram “the wheel of wealth,” and he used it as a teaching aide in his classes at the University of Iowa as early as the 1920s. Knight first published his diagram in some essays that he wrote in the early 1930s. Since that time it has become a fixture in economics textbooks worldwide.

More Detailed Information

The circular flow model concentrates on the relationship between the two primary groups of actors in the economy: households and businesses. Both households and businesses take in money, and both of them spend money on goods and services. Businesses and households interact with one another in two kinds of markets: the product markets and the factor markets.

The idea that businesses make money by selling products to households is probably familiar. Whether the products are tangible goods, such as lamps and automobiles, or intangible services, such as medical care or accounting work, businesses make money by exchanging these products for money with members of households. The exchanges are regulated by the forces of supply and demand. At the top half of the circular flow model, products move in one direction, from businesses to households, and income moves in the other direction, from households to businesses. This top half of the model encompasses the product markets.

The money that flows into the hands of businesses is not absorbed or simply stored by businesses, however. In order to continue functioning, businesses must spend money on the factors of production: land (including physical land and any natural resources needed in their operations), labor, and capital (money, buildings, equipment, and other goods). Businesses use the money they obtain in the products market to buy these goods and services from households on the factor markets. In the case of labor, it may be obvious that this is so. One or more members of most households work in order to pay for the things they and their family members need and want. Workers sell their labor to businesses in much the same way that businesses sell products to households. Thus, the money that households contribute to businesses in the form of purchases comes back to households in the form of payment for labor.

Less obviously, households ultimately sell the other factors of production to businesses as well. One of the main ways that households do this is by saving money in banks. When a worker takes a portion of his or her income and puts it in a savings account, the bank pays the worker interest. Meanwhile, the bank lends the worker’s income out to businesses that need it in order to buy land or to make purchases of capital, such as factory equipment, trucks, or computers. The businesses must pay the bank interest on the money they borrow. In this situation the bank is no more than an intermediary: the worker is ultimately lending money to the business for a fee. In other words, the household is selling its money, at a price, to the business.

The circular flow model is an intentional simplification of any actual market economy. The model’s validity is limited in several ways. First, the model assumes a straightforward market economy, whereas even the most market-oriented economies, such as that of the United States, are mixed economies. In a mixed economy the government asserts its influence on the economy with the intent of ensuring its stability, the well-being of citizens, or both. It influences the economy by implementing fiscal and monetary policies (fiscal policies regulate taxes and spending, and monetary policies control the amount of money in circulation), which can substantially affect flows of money and goods. Governments also have the power to regulate businesses and to affect the terms of their market interactions with households.

Another limitation in the basic circular flow model is that it does not take international trade into account. Not all products go to households within the economy; some products are exported to other countries, leaving the circular flow. Likewise, businesses from outside the economy sell their products to households within the economy in the form of imports. This means that money leaves the circular flow and goes abroad. The model also does not account for situations in which the levels of supply and demand fluctuate. Prices may be changed for reasons other than the natural functioning of market forces. For example, if consumer tastes shift, levels of demand would change, causing prices to change. This could result in inefficiencies in the economy that interrupt the circular flow.

Finally, the enormously complex financial industry may not be accurately accounted for by the basic version of the circular flow model. While the model assumes that individuals save or invest their money and therefore loan money to businesses on the factor markets, it may not adequately capture the complexity of investment types and of financial institutions in today’s world. Another financial industry detail not illustrated by the model is that when members of households deposit money in banks, banks are required by law to set aside a certain percentage of the money in order to have it on hand when people want to make withdrawals. This money does not flow through the economy but is simply in storage.

Recent Trends

The basic two-sector (households and businesses), two-market (products and factors) circular flow model has become a classic illustration of economic activity. It is usually presented in the early pages of introductory economics textbooks. As a simple way of understanding the interaction of businesses and households, it is still considered an effective tool. Economists, however, regularly attempt to fill in missing details and make the circular flow model more precise. Accordingly, there are numerous variations on the basic diagram. One variation retains the two-sector focus but adds a third market, the financial market, to the product and factor markets. Another alternative diagram adds a third sector, government, and attempts to account for taxes in the circular flow. Yet another appends to both these diagrams the foreign sector, yielding a four-sector, three-market model. Still other economists attempt to build circular flow models that account for other factors, such as environmental damage and the monetary costs that it imposes on an economy.