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Microeconomics The Circular Flow Model

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Principles of microeconomics. 2

Principles of microeconomics

The Circular Flow Model


The Circular Flow Model is a model found in macroeconomics and can be used by economists to depict an economy of a country. It determines the economy of a country since it is concerned with the flow of the money in the economy. The money is held by the public and circulates through transactions made. It therefore shows the distribution of income among the people. Economist all over the world have been interested in studying and analyzing the model to explain different economic phenomenon (Hall & Klitgaard, 2018). This has shown effort past years and has encouraged government to seek advice from policy makers on the interpretation of the model in relation to the economy.

Concept of Circular Flow Model

The circular flow model is an economic model that is used to represent how income is circulating in the economy. It is shows distribution of income as well. The circular flow model is divided into three sectors which include households, the firms and the government.

The household is considered the first sector in the flow model. Household are the consumers in the economy and are concerned of earning their income so that they are able to afford the good and services available in the market. Additionally, household are known to play an important role in the labor market as they provide laborers to firms and industries (Coulter, 2017). The main aim of searching job in firms is to sustain their lives, through this way money circulates in the economy.

The firm sector is in the model and their role is to produce and distribute goods and services. Firms and companies keep circular flow of businesses with the interest of obtaining and utilizing factors of production available. Business are source of current flow of cash, as they sell goods and services to the consumers.

The government plays an important role as it injects the money in the economy through spending and developing its projects. This helps in job creation whereby the households tend to get employed and therefore money circulates in the economy. Government spends on programs like the National parks’ administration and the social security. This will thereby enable the currency to circulate to the economy since tourist will pay for entry fees (Pirgmaier & Steinberger, 2019).

The model has been well interpreted by economists to show the relationship between these sectors in the flow model. These participants play a great role in ensuring there is currency circulation in the economy.

The Importance of The Model

The practice of circular economy is very important especially for the firms and industries. The practice act as a link between the consumers and the producers. The two parties are linked since the consumers will have to incur opportunity cost for a particular commodity. This kind of transaction brings closeness of the two market participants (Bruel, Kronenberg, Troussier & Guillaume, 2019).

Through the model, a well-established network of markets is created. This is as a result of the interaction between the customers and producers thereby creating a bond. Problems relating to purchases and sales are automatically solved through a convenient way. Network of market is created by the model since problems are solved.

The model highlights the importance of the monetary policy as it brings equality of investment and saving which is brought about by the capital market. The capital market is controlled by the government. It is argued that whenever savings exceed investments or vice versa, there is actions to be taken to ensure the balance or the equilibrium (Weng & Bake, 2016).

Importance of fiscal policy is realized through the circular flow model. The flow of currency has influenced the equilibrium of the money market. Through understanding of government spending and the concept of the taxation, an economist is able to depict the behavior of the economy.

The model has made better understanding of trade policies that are available in trade. Imports can be termed as leakages in the circular flow model since the are type of payment received from another country. To control this, the government initiates plans to reduce imports an increase export. The circular flow of currency has played a role in promoting the exports and import control strategies (Pirgmaier, 2017).

The circular flow of currency is important in calculation of national income on the basis of flow of funds account. Flow of funds account is interested in the amount of cash entering the economy. All money transactions are recorded therefore can be used to determine the growth of economy of a particular economy (Rajput & Singh, 2020).

Use of Flow Model to Explain GDP And Aggregate Demand (AE) And Aggregate Income

Gross domestic product (GDP) of a particular country is be equal to the Aggregate expenditure and the Aggregate income. The reason behind this argument is that when computing or calculating the GDP of a country, we use both income and expenditure approach. Expenditure approach implies what has speed spent on purchasing or buying a particular commodity. On the other hand, expenditure approach measures how much money earned as income on raw materials or resources available for manufacture.

The model, circular flow model depicts that both the expenditure and income approach must be equal. This implies that there exists equal benefit from both the buyer and the seller of a commodities; goods and services are flowing the same directions whereas the income flows in the opposite direction (Ariful, Atanu & Ashiqur, 2017).

The model illustrates equivalence of the income and the expenditure approach in calculation of national income of a country. Individuals purchases a commodity or service and their expenditures (money spent). On the other hand, firms will purchase resources such as labor which is being provided by the household whereby, they compensate the households through paying them (Oudshoorn, 2020). The money they are paid is used to purchase the goods of their preferences, this clearly indicates the opposite directions between the flow of income and the resources available.

Using the expenditure approach, GDP is calculated using the formula; Y=C+I+X-M whereby c is the consumption rate, I is the income, G represents government spending and M shows the exports. On the other hand, income approach formula is stated as; Y= w+i+r+p where w is the wage from laborers, I indicate interest rate earned on capital, r is the rent and p represent profits (Gao, Gao Song & Fang, 020). In general, if both the two formula are used and national income is calculated, the results obtained must be the same.

Using graphical illustration of the model, the aggregate expenditure can be used to depict the growth of GDP since they are equal.(Bruel, Kronenberg, Troussier & Guillaume, 2019).

By the use of the above graph, in a given economy, the state of equilibrium occurs when aggregate supply or production is equal to the aggregate expenditure. The economy is not at steady state since equilibrium level is not at a constant state. As the graph illustrates, a unit increase will lead to a equal significant increase in the level of GDP whereas income reduction per individual will result to the decrease in the GDP. When excess supply is experienced in the economy over time, the market forces tends to adjust to bring the economy at equilibrium. This implies that the price mechanisms will therefore adjust by reducing the prices or even reducing the quantity of the output produced in an economy (Mankiw, 2020). Therefore, we can dissect the above graph to show the attainment of level of equilibrium.

In figure 2 above, the desirable output; the equilibrium output is attained when the aggregate curve intersects the supply curve implying that the total amounts of goods and services supplied is equal to the income flow to the economy.  

Similarly, income expenditure can be also used to illustrate economic growth in terms of GDP growth by the use of graphs. The so-called Macro equilibrium is attainable when the aggregate income line across cut the aggregate supply. The equilibrium is at point E, Since the line cuts the origin at 45˚, the upper region represents the higher income level than the aggregate expenditure, to adjust this to equilibrium, firms will respond by reducing the production level.  The vice versa is true in case of low-income rate (Amusa & Oyinlola, 2019). This is explained graphically by figure 3 below; income is expressed in terms of $

Graphically construct an expenditure schedule, and use the income- expenditure (45-degree line) diagram to determine the equilibrium level of  GDP. |, Kronenberg, Troussier & Guillaume, 2019).


As discussed in the paper about the concept of the Aggregate expenditure and the Income expenditure method in determination of the real GDP of a country, it is therefore important for economists or learners to incorporate the Circular Flow Model and use it to explain the real life situation, that is integrating the graphical illustrations in demonstrating economic concepts of GDP, Income expenditure and the aggregate expenditure.

Since the paper also explores the importance of incorporating the currency flow circle, it’s upon the decision of each government to implement the best practices with aim of increasing the level of GDP, thus achieving the level of full employment in an economy. I Am therefore certain in advocating and advising countries to adopt the circular flow model so as to ensure full employment and efficient resource management.


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