Fundamentals of Business

Circular flow of income

Circular flow of income refers to a simple economic model which describes the reciprocal circulation of income between producers and consumers. In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households.

The circle of money flowing through the economy is as follows: total income is spent (with the exception of "leakages" such as consumer saving), while that expenditure allows the sale of goods and services, which in turn allows the payment of income (such as wages and salaries). Expenditure based on borrowings and existing wealth – i.e., "injections" such as fixed investment – can add to total spending.

In equilibrium, leakages equal injections and the circular flow stays the same size.
If injections exceed leakages, the circular flow grows (i.e., there is economic growth), while if they are less than leakages, the circular flow shrinks (i.e., there is a recession recession).
More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports.

The balance of trade (or net exports) is the difference between the monetary value of exports and imports in an economy over a certain period of time. A positive balance of trade is known as a trade su surplus rplus and consists of exporting more than is imported; a negative balance of trade is known as a trade deficit or, informally, a trade gap.

Why is important to understand circular flow?
When economy is booming booming, there is a feel good factor, households feel richer and spend more, firms invest more to expand and meet consumers demands, Financial institutions lend more, there is more money flowing through the economy and more activity and vice versa.
When there is economic gloom, households worry about their finances and spend less and save more, firms spend less as the demand is tight, Financial institutions offer less credit, there is less money flowing and therefore less activity in the economy.