The circular flow of income model was first introduced by French-Irish economist Richard Cantillon in the 18th century. Cantillon’s initial model was relatively primitive and was progressively expanded upon by Karl Marx and John Maynard Keynes, among others. The circular flow of income is a model that illustrates how money, goods, and services move between sectors in an economic system.
Understanding the circular flow of income
The circular flow of income describes the way money moves through society. In very general terms, money flows from producers to employees in the form of wages and then back to the producers as employees purchase goods and services.
In reality, however, the flow of money through society is far more complicated. In modern capitalist economies, several other parties participate in the flow of money. We will take a look at these in the next section.
The five sectors involved in the circular flow of income
The five sectors include:
The household sector
As we hinted at earlier, households receive income from firms in exchange for labor. However, they also receive money from governments with some of this money returning to the government in the form of tax.
The government sector
The key functions of the government sector are to purchase goods and services, collect revenue through taxes and other fees, and send money to households in the form of social security or welfare payments. If the government spends more than it receives in taxes, it must borrow money from financial markets.
The financial sector
The financial sector is perhaps the most important part of the circular flow of income because it encompasses the behavior of banks and other financial institutions. These companies receive household savings income and then make investments in other companies, with this linkage representing one of the most important ideas in macroeconomics. The financial sector also lends money to the government when required and receives money from foreign investment.
The foreign sector
Some suggest the foreign sector is the hardest to define because of the opaque nature of international transactions. Nevertheless, many of the goods produced in an economy are exported to other countries. The foreign sector is concerned with how resources including goods and currency are exchanged between two or more trading partners.
The firm sector
The flow of money in and out of a firm sector economy must balance. In other words, the total flow of money from the firm sector is the total value of production in an economy. Conversely, the total flow of money into the sector is equivalent to the total GDP expenditure. Households send money to firms for goods and services in a process called consumption. The financial sector can also invest in firms to help companies increase their output.
- The circular flow of income is a model that illustrates how money, goods, and services move between sectors in an economic system.
- The most simplistic interpretation of the flow of income suggests money flows from producers to employees in the form of wages and then back again in the form of consumption. However, modern capitalist economies are more complex.
- Five sectors describe the intricacies and interconnectedness of the circular flow of income. These include the household sector, government sector, financial sector, foreign sector, and firm sector.
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