Circular Flow Diagram

Circular flow diagram

• This is a visual model of the economy that shows how dollars flow through markets between households and firms

• The economy is broken down into two types of decision makers: firms and households.
  • Firms produce goods and services by using inputs, such as labor, land and capital (buildings and machine).
    • These inputs are known as the factors of production.
  • Households own factors of production and consume all the goods and services that the firms produce

• Households and firms interact in two types of markets:
  • Markets for goods and services
    • Households are buyers
    • Firms are sellers
  • Markets for the factors of production
    • Households are sellers
    • Firms are buyers

• The two loops of the circular-flow diagram:
  • Inner loop: shows the flow of inputs and outputs
    • The households sell the use of their labor, land and capital to the firms in the markets for factors of production
    • The firms then use these factors to produce goods and services, which are sold to households in the markets for goods and services.
  • Outer loop: shows the flow of dollars
    • Households spend money for buying goods and services from the firms.
      The firms use some of the revenue from these sales to pay for the factors of production, such as the wages of their workers. The remaining amount becomes profit for the firm owners.

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