An explanation of the parts of the circular flow of income

1. CIRCULAR FLOW OF
INCOME

2. • It is a model of the economy that shows the flow of
incomes (and expenditures) that result from choices of
the economic agents.

3. Simple two sector model/purely
private economy
 Sectors
 Business
 Hires factors of production
 Produces goods and services

4.  Households
 Supply resource services
 Purchase goods and services produced by firms

5. FACTOR & PRODUCT MARKETS
• The factor market is where the services of resource
suppliers are bought and sold.

6.  The product market is the place where goods and
services produced by firms are bought and sold.
 In the product market:
 businesses use the factors of production purchased to
produce goods and services.
 Consumers spend money on the goods and services.

7. REAL & MONEY FLOWS
 Real flows are:
 flows of resources that go from households through factor
markets to firms
 the goods and services that go from firms through product
markets to households
 Money flows are:
 the flows of payments made in exchange for the services
of factors of production
 expenditures on goods and services

8. FIG 2: A MORE COMPLICATED TWO
SECTOR MODEL

9.  The model can be extended to three sectors where
government is fully integrated into the flows.

10. THREE SECTOR MODEL

11. GOVERNMENT ACTIVITY
 Flows (5) through (12) represent the impact of including
government into the circular flow of income.
 Flows (5) through (8) illustrate that government makes
purchases in both product and resource markets.

12.  Flows (5) and (6) represent government purchases of
such products as paper, computers and military
hardware from private businesses.

13.  Flows (7) and (8) represent government purchases of
resources, government employs and pays salaries to
civil servants.
 Government then provides public goods and services to
both households and businesses as shown by flows (9)
and (10).

14.  To finance those public goods and services, businesses
and households pay taxes and this is shown by flows (11)
and (12).
Solid Waste
Tax could
increase
revenue

15.  Government changes up the circular flow.
 Reallocates resources
 Stabilises the economy
 Changes the distribution of income