The Circular flow of the Economy

The circular flow of the economy refers to how goods and services, as well as money, flows through the economy. Think of it this way. When you buy something, you exchange that product for money. The money you gave don't just stop right there, that money then gets used by the person you bought it from to buy something else.

If this sounds a bit confusing to you don't worry because luckily my brick wall economic theory can be used to explain a lot of things related to the economy. (If you don't know what the brick wall theory is, you can read all about it in my first post by clicking here.)

The modern circular flow of the economy usually has four major roleplayers:

• The households(consumers, ordinary people).
• The businesses(they sell you products and services).
• The government(they provide government services).
• The foreign markets(the place where import and exports go)

Circular flow of the economy

(Monetary -money- flow illustrated in blue and real flow illustrated in red)

In the case of the brick wall that my neighbour built there really is only two roleplayers as I am sure he didn't buy the bricks from someone outside the country, and the government also didn't intervene in any way in the building of the wall. Although because this is only a study and also a theory we will definitely look into it in the future of how the outcome of the wall could've differed if these two roleplayers were present.

Effectively we are left with only two roleplayers, the households and the businesses. This is totally fine as this will be enough to explain the basic concept of the circular flow of the economy. 

In the example of the brick wall, my neighbour is the household and the company who built the wall is the business.

The day my neighbour contacted the wall building company and settled on a price to build the wall, a market was created. A market is any place that buyers and sellers meet and agree on the price of which the product or service will be bought and sold. In economics, this market is referred to as the product market. The product market is where businesses sell there products or services and households buy products or services. The households exchange their money for the product they are buying.

The wall building company sold its products and services on the product market and my neighbour bought the products and services on the product market. When this happened there was a real flow of products from the business to the households and a monetary flow from the households to the business.

Household has the money and business has the bricks

Household has the bricks and business has the money

Now, this is all well and good, but you are probably wondering where the business got the workers from to build the wall. See in the economy there are things called the factors of production. It is also known in the study of economics that the households own the factors of production.

The four factors of production are:

• Land 
• Labour
• Capital
• Entrepreneurship

How do the households own these four things? It's actually really easy to understand. You, an ordinary person, can be classified as the household. How do you make money to buy things in the first place? You sell your labour for an income. Businesses need people to work in their factories or other divisions in their companies to produce goods to sell. The ordinary households can give the businesses that workforce.

Land refers to the resources needed to produce something. This can be anything from the materials needed to the actual piece of land used to build the factory on. Households own these things because they own the property on which these resources are gathered. They then basically sell these resources to the businesses.

Ordinary people like to feel that they are apart of something. Businesses offer this opportunity to them. The businesses need things like machinery, computers and construction equipment. These things are called capital. As you know everything in the world cost money so they offer households the opportunity to invest their money into these things to get interest in return. Without the capital investments, businesses won't be able to produce goods.

Most businesses started because an entrepreneur saw an opportunity to make money. Entrepreneurs are after all not another species but are ordinary people. Hence households own entrepreneurship.

By now knowing what the factors of production are and what the role of them is we can continue further and look to understand how businesses need them to do their thing. Back to the brick wall theory, we know that labour is needed to construct the wall. We also know that labour is owned by households. So essentially the wall building business hired ordinary people who are selling their labour to build the wall in return for money.

As we also know, when a buyer and a seller agree to a price at which to sell and buy their good or service a market is formed. The household(ordinary person) sold their production factor at a price and the business agreed to buy the production factor at that price. The factor market was created here.

The labourer sold their labour on the factor market and the wall-building company bought the labour. When this happened there was a monetary flow from the business to the household and there was a real flow of labour to the business.

Household owns the labour production factor

Household received payment for labour

All across the economy businesses buy factors of production from households and then turn it into products which they then sell again to the households. Money flows from the business to the households and then eventually back to the business again. And so the cycle continues. This is why it is called the circular flow of the economy. The same money circulates throughout the economy.

As you guessed not all of the money gets circulated back and forth like this because people need to pay taxes and do things like saving. We will be looking at the implications of these things called injections and leakages in a future post.

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