Circular flow model

The circular flow model maps an economy as two groups — households and firms — trading across two markets. In the resource (factor) market, households supply labor, land, and capital to firms and receive wages, rent, interest, and profit in return. In the product market, firms sell finished goods and services back to households in exchange for consumer spending. Money flows one direction around the loop while real goods and resources flow the other.

The model explains a foundational identity: because every dollar a firm spends on resources becomes income to a household, and every dollar a household spends becomes revenue to a firm, total output equals total income equals total expenditure. That identity is why gross domestic product can be measured three different ways — by production, by income, or by spending — and arrive at the same figure.

A simple two-sector loop is a closed system, but real economies leak and inject. Leakages — saving, taxes, and spending on imports — remove money from the domestic flow. Injections — investment, government spending, and export earnings — put it back. Adding the government and foreign sectors turns the two-sector diagram into the four-sector version, and the economy is in equilibrium when total leakages equal total injections.

The circular flow model is normally the first diagram covered in macroeconomics because everything else builds on it. AP Macroeconomics uses it to introduce national income accounting and the three approaches to GDP, and the CIMA Certificate Business Accounting syllabus uses it to frame how the domestic economy fits together before moving on to aggregate demand and supply.