Circular flow of income

The circular flow of income or circular flow is a model of the economy in which the major exchanges are
represented as flows of money, goods and services, etc. between economic agents. The flows of money and
goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow
analysis is the basis of national accounts and hence of macroeconomics.

The idea of the circular flow was already present in the work of Richard Cantillon.
This graph shows the circular flow of income in a five-sector economy. The flow of money is shown
with purple, and the flow of goods and services is shown with orange. Money flows in the opposite
direction from goods and services

Components and Flows

Households: Households provide resources (factors of production) to firms and receive national income in
return. They use this income to purchase goods and services and also save a portion of it.
Firms: Firms hire resources from households through the market for factors of production and use them to
produce goods and services. They earn revenue by selling these goods and services to households, the
government, and the overseas sector.

Market for Factors of Production: This market facilitates the flow of resources (labor, capital, land) from
households to firms. Firms make payments to households for these resources.

Market for Goods and Services: This market is where households, the government, and the overseas
sector purchase goods and services produced by firms.

Government: The government collects taxes from households and firms and spends on public goods and
services. It also engages in government expenditure, which flows into the market for goods and services
and investment expenditure, which affects financial markets.

Financial Markets: These markets facilitate the flow of savings from households and the government
(public savings) into investments by firms. Households save a portion of their income, which is channeled
into investment loans for firms.

Overseas Sector: This sector includes foreign trade, where households, firms, and the government engage
in exports and imports of goods and services.

Detailed Flows
Households to Firms (Market for Factors of Production): Households provide resources (labor, land,
capital) to firms and receive payments (wages, rent, interest, profits) in return. This is shown by the arrows
labeled "Resources" flowing from households to the market for factors of production and "Payment to
Factors" flowing back.
Firms to Households (Market for Goods and Services): Firms produce goods and services and sell them
to households, generating revenue. This flow is shown by "Goods and Services" going to households and
"Consumption" (spending by households) flowing back.
Households to Government: Households pay taxes to the government. The flow is labeled "Tax."
Government to Firms and Households: The government spends on goods and services (shown as
"Government Expenditure") and provides investment expenditure to financial markets. It also engages in
public savings, which flow into financial markets.
Financial Markets: Households save a portion of their income ("Private Savings"), which goes into
financial markets. The government also saves ("Public Savings") and may borrow (shown as "Public
Deficit"). These savings are used for investment loans to firms ("Investment Loan").
Firms to Market for Goods and Services: Firms sell goods and services to households, the government,
and the overseas sector, generating revenue ("Revenue").
Overseas Sector: This includes the export of goods and services from the market for goods and services
(flowing out as "Export") and the import of goods and services into the market (flowing in as "Import").