The Circular Flow of Income: Definition & Model

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  • 0:01 What Is Circular Flow…
  • 1:07 Key Terms & Circular Flow
  • 2:42 Example of Circular…
  • 3:07 Exceptions
  • 3:48 Lesson Summary
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Lesson Transcript
Instructor: Ryan Hultzman
In this lesson, we will look how the circular flow of income works. We will look at key terms, the roles of households and firms, and some exceptions to the model in terms of leakages and injections. A summary and quiz will conclude the lesson.

What Is Circular Flow of Income?

On any given day after work, we waltz into a store, grab items we need, pay for them, and head home. We then go on with our night-time routine, and wake in the morning to get ready to go back to work. This is a common flow of events for many people. While we obviously understand the main reason many people go to work is to earn money so they can purchase goods, what we probably do not give much thought to is how this cycle affects the economy. In other words, how does earning income, and then using that income to purchase goods, work? Well, to better understand this flow of money, we will need to explain the circular flow of income.

So what is the circular flow of income? How does it work? For starters, circular flow of income shows how money moves through an economy. In particular, it shows how money moves through businesses and individuals. To better explain this concept, let's take a look at some key terms.

Key Terms and Circular Flow

  • Households or individuals - This is a term used to describe consumers. For example, these are the people who earn money and then spend money.
  • Firms or businesses - Firms are the businesses and companies that produce the goods and services for households to buy.
  • Factors - In order for firms to produce goods, they need factors. These factors include capital, labor, and land. For instance, firms use capital to run their businesses. Individuals from households work for companies and provide labor. Firms can use land from households to build factories to make products.
  • Expenditure - This is term is used to describe the money that moves through the economy. This money is used to purchase goods and services from firms.

So, let's now put it all together. First, households go to work and earn money. This money is called income. The household then uses the income to purchase goods and services from firms. Next, firms use factors from households that consist of capital, labor, and land. Firms use these factors to produce the goods that households use their income to purchase. When the entire diagram is created, it shows the money, which comes from individuals or households through purchases and factors, become the income of the businesses. The money of the businesses, through salaries paid and goods produced, becomes the income of the individuals.

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