How does the circular flow of income work?

How does the circular flow of income work?

We go to shops or markets every day and spend our money on goods. Then, when we need money, we go and earn it. And we do this day by day. Familiar scheme? We guess, yes! But did you know that this scheme forms the basis of human society in a broader way then you could have ever imagined? If you are interested, then go on reading, because today we will speak about the circular flow of income and how it works.

The circular flow of income work peculiarities

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Economics became the basis of human life a long time ago. When we say “a long time ago” we mean, of course, the pre-historical period of first good exchange. People always had some imagery about the notion of mutual benefit. Today Legit will try to explain you in details and simple words the way this circulation of “mutual benefit” works today. So go on reading!

What is the circular flow of income?

The circular flow of income is the flow of goods and services between producers and consumers through money circulation, cash flow through financial markets, government activities, and the movement of products and services.

At the same time, economic benefits move not on their own but act as a means of communication between economic agents. Besides, there are two main types of economic agents: households (families) and firms (producers). The first group owns all the productive resources of the society; the latter one uses them in the production process. Supplies are incredibly diverse, but they can be grouped into so-called production factors. There are four such factors: labour, money, natural resources, and entrepreneurship.

Actually, the exchange of income between households and forms is the most straightforward representation of the term Circular Flow of Income where Money goes to workers in the form of the salary, and the same money comes back to organisations in exchange for goods.

Principles of the circular flow of income

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In the theory of economics, it is called a two-sector model. More realistic presentation about circulation in the economics gives a five sector model where besides the two sectors mentioned above, the government, banks and the rest of the world are included.

Let us divide the Circular Flow into two different parts: micro (inside the state) and macro (outside the country) and see their peculiarities in a more detailed way.

The domestic circular flow of income and spending

The cycle of goods and income can be represented as the simplest model of economic circulation or the model of distribution in the private sector of the economy (not considering the foreign industry), where two representatives cooperate: households and firms. To better understand this model, we note the interaction of its participants:

  • Households are economic agents who possess all the resources, or factors of production (capital and labour), buy all the goods and services produced by firms for consumption and spend all their incomes on it;
  • Organisations do not possess any primary resources, they purchase them from households and market them to those who need products or services;
  • Families purchase products and services offered to them for the income they earn working on firms or organisations; their income is presented as wages or dividends.

Thus, households assure firms with work power and other sources; organisations use these items for the creation of new goods for consumption and services for these very families (households). And so on to infinity — as long as there are needs and resources, households and firms, as long the humanity will exist. The principle of the economic cycle is similar to a circle in nature: water evaporates from the ground and comes back in the form of rain.

The circular flow of income in an open economy

The circular flow of income

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Speaking about the world flow of income, one means the sum of exports of all countries of the world, expressed in the most stable currency of the world — US dollars. Foreign trade includes such concepts as export and import. Under the word export, we understand the volume of goods that are exported from the state for a certain period. Of course, these goods must be produced within this country. And under import, they understand the volume of goods that are imported into the state from the outside (from other countries). Imported goods are produced outside of a specific state. Due to foreign exports, money is added to internal circulation.

An essential part of assessing the state's economy is such a notion as the balance of international flow of income. As a rule, the balance of foreign trade of a particular country is either positive or negative. If we subtract the cost of imported products from the exported ones, we get a number with the sigh + or -. The number with the index + speaks about the economic growth of the country. We mean that the state sells more than buys and has no need for spending money from the domestic budget.

That is why the wealthiest countries of the world like the United Kingdom, the USA, Germany, China, and many others produce their goods, machinery, technique, etc. and improve the domestic circular flow of income and spending.

The regularity of the circular flow of income
Source: Getty Images

Nigeria, for instance, has good export circulation with India, the USA, France, Spain, and the Netherlands and the import one with such countries as China, Belgium, South Korea, and the USA. For example, according to, Nigeria exported $46.8B and imported $34.2B in 2017. It means, that out of this circulation, the country filled national budget with $12.7B.

In conclusion, it is necessary to say that the model of economic circulation is sufficiently correct to describe an industrial society, but it is difficult to use it to characterise modern post-industrial society. In an industrial society, production was mainly moved outside the household, into the outside world, and the house was viewed as a place of rest and recuperation. New products, first of all, electronic devices, allow to combine work and rest in the house. Already, many experts (programmers, designers, marketers, managers, academic theorists, journalists, etc.) work mostly at home on a computer, without wasting time moving from home to office and back. Subsequently, in the future, because of computerisation, the interaction between the household and the firm will be increasingly weaker.

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