Circular Flow of Income
Visual guide to how money flows between households, firms, government, and the rest of the world in a modern economy.
The Basic Model
Two-sector model — households and firms exchanging goods and services.
The circular flow model is one of the most fundamental concepts in economics. It shows how money, goods, and services flow between the major actors in an economy.
The Simplest Model: Two Sectors
In the basic model, there are just two actors:
- Households — Own the factors of production (labor, land, capital) and consume goods/services
- Firms — Produce goods/services and hire factors of production
The Two Flows
Money flows in a circle between households and firms:
- Factor market — Households sell labor to firms → Firms pay wages to households
- Product market — Firms sell goods to households → Households pay money to firms
This creates a continuous loop: households earn income from firms, then spend it on products from firms, which gives firms the revenue to pay households.
Key Insight: One Person's Spending Is Another's Income
This is the most important lesson of the circular flow. When you buy groceries, your spending becomes the shopkeeper's income. When the shopkeeper pays rent, it becomes the landlord's income. Total spending = Total income in the economy.