The Simple Circular Flow Model

In its simplest form, an economy consists of buyers and sellers. Sellers are businesses that obtain resources, including land, labor, capital goods, and raw materials and use these to produce and sell goods and services. Households provide (sell) their labor to businesses, and use the income to buy products. Households also may own land, capital (money), capital goods, and raw materials which can be used for production.

In the graph below, a simple circular flow diagram shows the economic interactions between households and businesses. This paints a simplified picture of how our economy works.

The Circular Flow with Government and Foreign Markets

A more realistic picture of our economy also incorporates the economic interactions of two other main participants in our economy: a 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.

For a video explanation of the circular flow, please watch the following: