A circular flow model is a diagram illustrating how the major sectors in a mixed-capitalism economy fit together. Circular flow models show how the value of output equals income in an economic system. The model also demonstrates the mutual interdependence of the various participants in an economy.
The five sectors in the model are households, firms, financial intermediaries, the government, and foreign countries. Households own and determine how to allocate resources—human, capital, and natural. For example, household members decide where and how to use their labor resources; control the use of any equipment like a computer or a machine; and control the use of land, minerals, or other natural resources they own. In a noncapitalist economic system, households control only a small percentage of resources, while the government controls most resources.
In capitalist economies, households receive payments for the use of their resources from firms or the government, depending on who purchases the resource. Gross household income is the sum of resource payments received. Households with greater resources receive more income than those with fewer resources. The quality of resources also influences the amount of income received. Education, an improvement in human capital, typically results in greater income. Likewise, land with minerals, beautiful views, or a lakeside site is more valuable than barren or polluted natural resources.
Households take the resource payments they receive and primarily use this income for consumption spending—payments to firms for products and services. Some household income is saved, usually by depositing a sum with financial intermediaries, and of course some household income is taken by government in the form of taxes.
A circular flow model shows that firms complement the actions of households. Firms purchase or rent resources, paying wages, interest, dividends and profits to households, and use the resources to produce goods and services, which are then sold to households, the government, and foreign buyers. Firms that produce goods and services most desired by consumers will receive a greater portion of the flow of payments, allowing these firms to purchase more resources, produce more goods, and, in essence, grow. Those firms that produce products consumers do not want or only will purchase at lower prices see their revenue decline and eventually will be forced out of business.
In a mixed-capitalism circular flow model, the government plays many roles. The government purchases resources from households and provides goods and services to both households and firms. Employing teachers is an example of a government resource purchase to provide services to households. The government taxes portions of income from both households and firms. Changes in taxation redistribute the burden of paying for government goods and services among households and between households and firms.
Financial intermediaries primarily aggregate savings from many households and provide investment capital to firms. In the process financial intermediaries reduce investor risk through knowledge of investment alternatives and portfolio diversification. Intermediaries also adjust for the diverse needs of savers. Households have many different levels of savings and periods of time they are willing to lend their savings. The savers’ time frame and dollar amount preferences are unlikely to mesh with the needs of firms borrowing funds for investment. Financial intermediaries smooth the process of lending and borrowing in financial markets.
Foreign countries, through relationships with U.S. businesses, sell products and services to American consumers and purchase products and services from U.S. firms. Trade balances measure the net impact of exporting and importing in the circular flow model.
Close inspection of a circular flow model shows that for each “real” flow of resources or goods and services, there is an opposite money flow. One of the major roles of monetary policy is to provide the “right” money supply to facilitate exchange of resources and goods in an economy. The “right” money supply is subject to debate and constant change as an economy grows or declines.
As stated earlier, one of the uses of circular flow models is to show how the value of output equals income in an economic system. Measuring either the flow of payments (income) or the value of goods and services (output) results in an estimate of the level of economic activity in an economy (gross domestic product).
The circular flow model is analogous to the circulatory system in the human body. In the economy, the efficient flow of money between savers and borrowers is provided by financial intermediation, the process of bringing borrowers and savers together via financial intermediaries. Payments for goods and services (business revenues) flow in one direction, and payments for the factors of production (household incomes) flow in the opposite direction. One’s spending becomes another’s income. In the human body, blood flows from the heart via arteries and to the heart via veins. Just as leakages in the human circulatory system will cause declining performance, leakages in the circular flow model hamper the spending/income process, causing declining economic performance.