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Circular Flow Diagram

Circular Flow Diagram

Author: Kate Eskra
This lesson covers the circular flow diagram.
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Source: Images of Circular Flow Diagram created by Kate Eskra

Video Transcription

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on the Circular Flow Diagram. My examples for you will be in green. In this tutorial we'll be talking about how the circular flow diagram shows us this big picture of the economy. And it shows the interactions between households, firms, the government, and the rest of the world.

Consumers, firms, and the government play different roles in terms of supply and demand. And I'll show you that in the different markets. The two markets that I'll show you are the input, or factor market, and the output market. Finally, these two different markets really give us two different approaches to calculating GDP. And even though that's the subject of another tutorial, while we have the diagram here it's worth showing you how we can look at it that way.

So the circular flow diagram is this model that's really used to show us a big picture of how the economy overall is functioning. Keep in mind that no model could show us every single interaction. So it is a simplified model. The interactions that it can show are between households and firms. And that's actually where I'm going to start. I'm going to draw you your first circular flow diagram by just having the interactions between households and firms. And then I'll add in the government, and finally I'll add the rest of the world.

The two markets that we show on the circular flow diagram are the output market, first of all. And in the output market that's where we exchange goods and services. So how I was involved in the output market this weekend are two things. I went grocery shopping yesterday. So I physically took goods home with me after I went grocery shopping. But also got my hair cut. Even though I didn't bring a new good home with me, I purchased a service.

But then we also have the input market. The inputs, remember, are also called factors of production. They're also resources. These are land, labor, and capital. And it's how outputs are produced. So the input market is where we exchange our factors of production, like I said land, labor, and capital. And how I'm involved in the input market is with my labor. In order to afford purchasing anything up here, I have to go to work in order to afford those things.

The diagram is going to include two different kinds of flows. One is a physical flow. And so when I brought those goods and services home with me that was physically me purchasing them and bringing them home with me. And also when I physically go to work and provide my labor that is a physical flow. So land, labor, and capital, goods and services are the things being exchanged.

But in return for those things, money is being exchanged. And so the monetary flow is another flow. I will represent the monetary flow in green, and the physical flow in blue. So let's take a look at it.

Here again, remember I told you. I'm going to add in the government and the rest of the world in a couple of slides. But I wanted to show you this as a more simplified model, just so that you get a hang of how these arrows are all working here. So the output market is up here. And notice that the blue arrow represents those things coming home with me. So here the groceries are coming home with me from the grocery store. But I didn't steal them. I paid money to the grocery store in return for them. So I give money, the business provides me with the goods or services.

Down below, I will go to work tomorrow. So I will drive to work and provide my labor to the school district. And in return, every other Friday, the school district will pay me. So that's how those things work.

Notice that the green arrow, the monetary flow, is moving in a counterclockwise fashion. And the blue arrow is moving in a clockwise fashion. And it's kind of neat to recognize this, because you can see that we are going to play different roles, depending on what market we're involved in. We can see that on the next slide.

So we have up here are the demanders. We are demanding goods and services. And the firms are supplying them to us, like I showed you before. We pay money, and we get to bring them home with us.

But in the bottom, now we have different roles. Firms are the ones to demanding land, labor, and capital from us. Without our land, our labor, and our capital, they couldn't produce or supply anything to us in the output market. But we are now the ones supplying land, labor, and capital in the input market.

OK. Now let's add the government. So notice that I added the government in the middle, because the government obviously interacts with both firms and households. So first of all on the business side of things, the government obviously collect taxes from firms. Notice that I took away the blue arrows, because it was just way too much, too complicated, if I put that physical flow on here. So just notice that, or keep in mind that for every green arrow there would be a blue arrow in the other direction. But this is just the monetary flow. So that's why firms are paying taxes to the government.

But the government also interacts in the output market with firms by paying for certain goods and services. For example, if the government would contract out with a business for maybe them to produce the military goods for them, they would be paying money to that business for those goods or those services. Here where the firms are paying taxes, the government is also going to intervene sometimes with things like subsidies or regulating businesses. And one thing that I want you to keep in mind is that those kind of interventions can alter the original supply and demand market between firms and the government. And you'll see that in future tutorials. But I wanted to mention it here.

On the household side, the government obviously collect taxes from us. We are very aware of that. So you see money going from households to the government. The government though also pays households in different ways. There are transfer payments that go from the government to households in the form of, let's say, social security or really any kind of welfare payments. They're also going to pay households if in fact at that household has any government employees. So many people in our country work in some kind of government capacity. And then money would be flowing from the government to households in the form of wages.

Finally, let's add in the rest of the world. So I put the rest of the world up top here. And there are two ways that we interact with the rest the world. The first way is when we pay the rest of the world for imports. Let's say we buy cars from Germany. So we import cars from Germany. We would have to pay Germany for those cars.

But on the other side here, where the rest of the world is paying our firms that would be the exports. So when foreigners purchase things from us, maybe they pay our farmers for grain, for example. That is represented by that arrow.

OK. Finally, there are two different approaches to calculating GDP, our Gross Domestic Product. And that is a subject of a future tutorial. But while we have this circular flow diagram here it's helpful just to see it right now. So let's talk about it for a minute.

One way of measuring how productive our country is is to add up all of the things that we spend money on. And so that would be up here in the output market. So I've highlighted all of the output market arrows in yellow so that you can see that that's how we would calculate GDP using the expenditure approach. Now one of the things that we would have to do is we would obviously add foreigners when foreigners are purchasing things from us. We would add those export purchases in. But we would have to subtract out all of the things we purchase from other countries. Because those things would not represent productivity from the United States standpoint.

Another way of calculating our GDP is by using the resource costs or income approach, so all of the income, all of the ways that people are working or providing land, labor, or capital in our country. And that would be by adding up all of the interactions in the input market. So the wages, the rents, interest, profits that are paid for land, labor, and capital would be calculated using this approach.

And believe it or not, these two different approaches, although they're vastly different, should arrive at the same number. Because if you think about it, every time I spend money somewhere up here that becomes a part of somebody else's income down here in the input market.

OK. So what you learned in this tutorial is all about the circular flow diagram, and how it really shows us this big picture of the economy, the interactions between households, firms the government and the rest the world. You looked at the two different markets. And you were able to see that depending on the market involved, we're either supplying or demanding, and so are firms

And then finally I ended by showing you how these two different markets can give us the two different approaches to calculating GDP. Thank you so much for listening. Have a great day.