Lessons in Macro Economics - Closed Economy Circular Flow Diagram

This graph represents a more realistic model of the economy as compared to the earlier model that only included households and firms. The green arrows represent how money moves between economic actors (red boxes) through different markets in the economy (orange boxes.)

Households receive income from supplying their labor. They use this money to save money in financial markets (banks, etc), pay taxes to the government, and consume goods and services from the private sector.

Firms take payments from households and government purchases in order to produce goods and services. They also have to pay households for their labor and the rest is reinvested through financial markets.

Governments collect taxes from households and make capital outlays, which benefit society in the form of infrastructure, schools, public safety, etc. Whatever is left over gets reinvested through financial markets.

This is still a simplistic model, but it helps to understand how various sectors of the economy work together to produce its Gross Domestic Product. Our model does not yet include imports and exports in foreign markets, which we'll get to later.

Lessons in Macroeconomics - Circular Flow Model for Closed Economy

We are going to start with a simple closed economy, and I'll introduce a slightly more complicated model which includes banks, government, and net exports later.

First we assume that there are only two sectors in the economy - individual households and firms. Households are concerned with consuming goods, whereas firms are concerned with producing goods that households want to buy.

Here is a sample graph of this two sector closed economy.



Households supply their labor (inputs) to businesses which is indicated by the blue arrow on the top. Then businesses use their labor in order to produce goods and services which it then sells to households, which is indicated by the blue arrow on the bottom. These are called factor markets.

Businesses also pay households money in exchange for their labor, which is indicated by the red arrow on the top. Households then use this money in order to purchase goods and services from businesses, which is the red arrow on the bottom. These are referred to as financial markets.

Money simply flows around the economy back and forth between businesses and households, and in this closed economy scenario they are exactly equal. No new money is ever created.

Next, I'll introduce a slightly more complicated model which includes banks and the government.