The Simple Circular Flow Model
An economy consists of many persons and groups who participate in various economic activities. In its simplest form, an economy consists of buyers and sellers. Sellers are mostly businesses that produce goods and services. Businesses also buy resources, including land, labor, capital goods, and raw materials. Households buy consumer goods and services that are produced by the businesses. Households also provide labor necessary to make these products. Those households that own land, capital (money), capital goods, and raw materials provide these resources for production.
In the graph below, a simple circular flow diagram shows the economic interactions between households and businesses. This represents a simplified picture of how our economy works.
A simple circular flow diagram
The Circular Flow with Government and Foreign Markets
A more realistic picture of our economy includes the households and business activities described above, and also incorporates the economic interactions of two other main participants in our economy: government and foreign markets. This is illustrated in the diagram below.
Governments provide services to businesses, households, and foreign markets, and collect taxes to pay for these. Foreign markets buy and sell goods and services to and from our households, businesses, and governments.
So a typical economy consists of four main groups: households, businesses, governments, and foreign markets. The circular flow model illustrates the interactions between these four groups.
A circular flow diagram with government and foreign markets
For a video explanation of the circular flow, please watch the following: