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.