A description of the circular flow model of economics
The government sector includes all the government agencies on a local, state, and federal level, which are responsible for the legislation and the proper functioning of the market. Technically, employees can more accurately be thought of as being rented rather than being sold, but this is usually an unnecessary distinction.
The fact that the arrows on the money lines and the arrows on the product lines go in opposite directions simply represents the fact that market participants always exchange money for other stuff.
Circular flow model explained
Leakages reduce the flow of income. Technically, employees can more accurately be thought of as being rented rather than being sold, but this is usually an unnecessary distinction. The government injects money into the circle through government spending G on things like welfare programs and infrastructure. The injection provided by the government sector is Government spending G that provides collective services and welfare payments to the community. Injections can take the forms of investment, government spending and exports. The households spend their entire income on goods and services and do not save any money. To increase sales and profits, these companies use factors of production—labor, capital, and land—to run their operations and grow their businesses. Households Can Provide Things Other Than Labor One common question regarding this model is what it means for households to provide capital and other non-labor factors of production to firms. This means that income individuals receive from businesses and the goods and services that are sold to them do not count as injections or leakages, as no new money is being introduced to the flow and no money is being taken out of the flow. The income the government receives flows to firms and households in the form of subsidies, transfers, and purchases of goods and services. The model represents all of the actors in an economy as either households or firms companies , and it divides markets into two categories: Markets for goods and services Markets for factors of production factor markets Remember, a market is just a place where buyers and sellers come together to generate economic activity. Often, the government is the largest, if not the only buyer of a product i.
Money that is used to pay foreign entities for goods and services through imports M also constitutes a leakage. Two-sector model[ edit ] Two-sector circular flow diagram In the basic two-sector circular flow of income model, the economy consists of two sectors : 1 households and 2 firms.
Goods and Services Markets In goods and services markets, households buy finished products from firms that are looking to sell what they make.
In general, the circular-flow model is useful because it informs the creation of the supply and demand model. The level of injections is the sum of government spending Gexports X and investments I.
Flows from households and firms to government are in the form of taxes.
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