The circular flow model starts with the household sector that engages in consumption
spending and the business sector that produces the goods.
Two more sectors should also be included in the circular flow of income, the government
sector, and the foreign trade sector. The government injects money into the circle through
government spending on programs such as Social Security and National Parks
administration. Money also flows into the circle through exports , which bring in cash from
foreign buyers. In addition, businesses that invest money to purchase capital stocks
contribute to the flow of money into the economy.
Just as money is injected into the economy, money is withdrawn or leaked through various
means. Taxes imposed by the government reduce the flow of income. Money paid to foreign
companies for imports also constitutes a leakage. Saving by businesses that otherwise
would have been put to use are a decrease in the circular flow of an economy’s income. A
government calculates its gross national income by tracking all of these injections into the
circular flow of income and the withdrawals from it.
The external sector involves businesses exporting goods and services overseas and
consumers and business buying imported products from other countries. 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.
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.
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.
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.