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ECONOMICS MACROECONOMICS
Circular Flow Model
Definition and
Calculation
By THE INVESTOPEDIA TEAM Updated October
30, 2023
Reviewed by ERIC ESTEVEZ
Fact checked by JARED ECKER
What Is the Circular Flow Model?
The circular flow model demonstrates how
money moves through society. Money
flows from producers to workers as wages
and flows back to producers as payment
for products. In short, an economy is an
endless circular flow of money.
Related Terms
Leakage: Definition in
Economics and Examples
Leakage is an economic term that describes
capital or income that escapes an economy
or system in the context of a circular flow of
income model. It results in a gap between
supply and demand. more
Gross Domestic Product
(GDP): Formula and How to
Use It
Gross domestic product is the monetary
value of all finished goods and services
made within a country during a specific
period. more
Personal Consumption
Expenditures (PCE): What It Is
and Measurement
Personal consumption expenditures is a
measure of consumer spending and includes
all goods and services bought by U.S.
households. Learn more about PCE and how
it's used. more
Paradox of Thrift: Definition
in Economics, Examples,
Criticisms
The paradox of thrift posits that individual
savings rather than spending can worsen a
 savings rather than spending can worsen a
recession or that individual savings can be
collectively harmful. more

Aggregate Demand: Formula,

Components, and Limitations
Aggregate demand is a measurement of the
total amount of demand for all finished
goods and services produced in an
economy. more

Macroeconomics Definition,
History, and Schools of
That is the basic form of the model, but
Thought
actual money flows are more complicated. Macroeconomics studies an overall economy
Economists have added in more factors to or market system, its behaviors, the factors
better depict complex modern economies. that drive it, and how to improve its
performance. more
These factors are the components of a
nation's gross domestic product (GDP) or
national income. For that reason, the
model is also referred to as the circular
flow of income model.

Related Articles
KEY TAKEAWAYS
The circular flow model The faucet broke Gross Domestic
demonstrates how money moves the money and Product (GDP)
from producers to households and leaked out Definition
back again in an endless loop.
In an economy, money moves
from producers to workers as
wages and then back from
workers to producers as workers
spend money on products and
services.
The models can be made more
Expenditures
Cash
 Expenditures
complex to include additions to Cash
(PCE): A measure
the money supply, like exports,
of how much U.S.
and leakages from the money
households spend
supply, like imports.
on goods and
When all of these factors are
totaled, the result is a nation's
gross domestic product (GDP) or
the national income.
Analyzing the circular flow model
and its current impact on GDP can Graduates
help governments and central Man reviewing
throwing
banks adjust monetary and fiscal containers
mortarboards in
policy to improve an economy. the air

Circular Flow Model

Investopedia / Alex Dos Diaz

Understanding the Circular Flow

Model
The basic purpose of the circular flow
model is to understand how money moves
within an economy. It breaks the economy
down into two primary players:
households and corporations. It separates
the markets that these participants
operate in as markets for goods and
services and the markets for the factors of
production. Other sectors can be added for
more robust cash flow tracking.

The circular flow model is used to measure

a nation's income, as the circular flow
model measures both cash coming into
and exiting a nation's economy. It is also
used to gauge the interconnectivity
between sectors as a fully robust and
strong economy will have interaction
between components. For instance, the
relationship between a government's
taxation policies and a household's
consumption spending will have a direct
impact on a business's ability to sell goods.

The circular flow model is aptly named

because funds tend to continuously flow
between sectors. As highlighted in the
diagram below, money often flows from
one sector to another, awarding benefits
along the way. No single sector should
hoard or collect all resources; instead, a
fully-functioning circular model will
continuously move funds so each sector
can operate appropriately. Note that this Partner Links
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Sectors of a Circular Flow Model
There are different types of circular flow
models, each with a different number of
sectors it tracks. Below are the potential
sectors that could be included in a circular
flow model. Each sector within a circular
flow model may be designated with a
capital letter often used to describe how to
calculate GDP.

Household Sector
In a two-sector model, circular flow
models start with the household sector
that engages in consumption spending (C).
Households contribute to an economy by
working (giving away time and labor) and
by buying products (giving away money).
In return, households consume products
and utilize government programs.

Business Sector
In a two-sector model, circular flow
models also include the business sector
that produces the goods. Businesses
absorb a variety of production costs
including labor, materials, and overhead.
As a result, many companies are able to
manufacture products that benefit other
parties.

Government Sector
In a three-sector model, government
sector cash flows are included. The
government injects money into the circle
through government spending (G) on
through government spending (G) on
programs such as Social Security and the
National Park Service. It also extracts
money from households and businesses
by way of taxes.

Foreign Sector
In a four-sector model, money also flows
into the circle through exports (X), which
bring in cash from international buyers
from the foreign sector. By extension, this
indicates that the two-sector or three-
sector models are domestic activity only.
The foreign sector is different from the
domestic sector as there may be
administrative inefficiencies that result in
lost cash flow due to import taxes, duties,
or fees.

Financial Sector
In a five-sector model, cash flow from the
financial sector is added. This includes
banks and other institutes that provide
cash flow via lending services. Some
circular flow models also outline investor
activity, as cashflow from entrepreneurs
and investors may represent an inflow to
businesses while net profits from the
company represent an outflow.

Important: A change in one

sector may critically change the
rest of the circular flow model.
For example, imagine if
governments doubled individual
tax rates. This change would
likely have major repercussions
 likely have major repercussions
on business, individuals, and
other sectors within the circular
flow model.

Circular Flow Model: Injections

and Leakages
Just as money is injected into the
economy, money is withdrawn or leaked
through various means as well. Taxes (T)
imposed by the government reduce the
flow of income. Money paid to foreign
companies for imports (M) also constitutes
a leakage. Savings (S) 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 circular flow of
income for a nation is said to be balanced
when leakage equal injections. That is:

The level of injections is the sum of

government spending (G), exports (X),
and investments (I).
The level of leakage or withdrawals is
the sum of taxation (T), imports (M),
and savings (S).

When G + X + I is greater than T + M + S, the

level of national income (GDP) will
increase. When the total leakage is greater
than the total injected into the circular
flow, national income will decrease. As
flow, national income will decrease. As
long as a country's injections is greater
than its leakages, a country's economy can
theoretically remain sustaining forever.
However, if there are cash flow shortages
(i.e. leakages), the country must find
additional cash flow to compensate for the
shortage.

Calculating Gross Domestic

Product (GDP)
GDP is calculated as consumer spending
plus government spending plus business
investment plus the sum of exports minus
imports. It is represented as GDP = C + G + I
+ (X – M).

If businesses decided to produce less, it

would lead to a reduction in household
spending and cause a decrease in GDP. Or,
if households decided to spend less, it
would lead to a reduction in business
production, also causing a decrease in
GDP.

GDP is often an indicator of the financial

health of an economy. A common, though
not official, definition of a recession is two
consecutive quarters of declining GDP.
When this happens, governments and
central banks adjust fiscal and monetary
policy to boost growth.

Keynesian economics, for example,

believes that spending leads to economic
growth, so a central bank might cut
interest rates, making money cheaper, so
that individuals will buy more goods, such
that individuals will buy more goods, such
as houses and cars, increasing overall
spending. As consumer spending
increases, companies increase output and
hire more workers to meet the increase in
demand. The increase in employed people
means more wages and, therefore, more
people spending in the economy, leading
producers to increase output again,
continuing the cycle.

$25.7 Trillion
The United States GDP as of Q3
2022.

Example of Circular Flow Model

Consider a circular flow model involving
Apple employees and Apple product
consumers. In this example, we'll also
include the government to form a three-
sector circular flow model.

From the household/consumer

perspective, there are several factors to
consider. First, households may spend
money and in return, the households get
new innovative technology products.
Second, households may be employed by
Apple. Households may contribute labor
hours and time to the company resulting
in Apple growing and becoming a more
successful company. Households receive
income from Apple, though part of these
funds is given to the government via taxes.
Households then benefit from government
programs.

From the business perspective, the

company exists to create products. From
above, they sell products and take money
from households. They also take time for
workers to make those products. A certain
portion of the company's profits is given to
the government in the form of taxes. In
some cases, Apple may benefit from
government programs or subsidies, so part
of these tax dollars may indirectly benefit
Apple.

From the government's perspective, both

households and business pay taxes. These
dollars are then used to deploy capital
projects or public programming, both of
which may benefit Apple, its employees, or
its customers.

In this example, additional sectors (or

additional flows) could be added. For
example, Apple is an international
company that sells goods around the
world. Another example is how investors
may contribute money into Apple in return
for a portion of the company. This example
highlights the complexity of the circular
flow model as inputs and outputs are
continually cycling throughout a
systematic economy.

What Is the Outcome of a Circular

Flow Model?
A circular flow model doesn't necessarily
end or have an outcome. Instead, it
describes the current position of an
economy regarding how its inflows and
outflows are used. This information can be
used to make changes about the economy.
For example, if a country realizes it has
deficient national income, it may choose
to reduce its imports and scale back
certain government programs.

Why Is It Called a Circular Flow

Model?
The economy often moves in a circle as
money flows from one sector to another.
Households spend money and businesses
use that money to create new, better
products for the households to buy in the
future. Meanwhile, the businesses pay
households for their time in helping
develop those products. After adding in
governments, investors, and foreign
markets, the circular flow model depicts
how cashflow moves money from one
sector to the next in a systematic,
organized way.

What Are the Limitations of a

Circular Flow Model?
A circular flow model depicts where an
economy is now. However, it fails to clearly
communicate how a change in one
variable may impact all other flows. For
example, economists may struggle in
determining how a 5% increase in
unemployment may impact the circular
flow model. Though it's understood that
reduced income may lead to less
consumption and less tax revenue, a
circular flow model may not explain how
one change will numerically change other
values.

The Bottom Line

Our global economy is incredibly
interconnected, and this is often
graphically depicted using the circular flow
model. The circular flow model details
how resources flow into and out of
households, businesses, governments,
investors, markets, and foreign entities.
This cycle shows how the resources of one
sector are used to develop others in a
cyclical manner.

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