A CIRCULAR FLOW MODEL OF THE ECONOMY

Dr. Gary Stone, Winthrop University

The workings of an economic system are very complex because of the large number of individuals, groups, and institutions that are involved in an economy. A circular flow model is a simplified view of the relationships that exist among the various sectors and markets of an economy. A real flow is the movement of goods, services, or resources. A money flow is the movement of money between two sectors.

The household sector represents individuals and families that : (1) provide resources and (2) buy goods and services.

The business sector is composed of the firms that: (1) buy resources and (2) produce goods and services .

The government sector provides certain goods and services and collects taxes from the household and business sectors. It also provides support to certain members of the

household and business sectors. Transfer payments are made by the government to

individuals in the household sector for which no services were provided by those individuals.

Examples of transfer payments are welfare assistance and unemployment compensation.

Subsidies are various forms of assistance the government provides to certain businesses or

industries. Examples of subsidies are tax breaks and financial support by the government.

The foreign sector represents the sum of households, businesses, and governments from other countries that somehow are involved with the U.S. economy. [The circular flow model illustrated below is called a “closed economy” because it excludes consideration of the foreign sector to keep the presentation simple.]

The product markets are the markets where the buyers and sellers of all the different goods and services in the economy interact to determine the price and output of each item.

The resource markets are the markets where the buyers and sellers of the four types of resources (labor, land, capital, and entrepreneurship) interact.