The Circular Flow Diagram: definition, examples and more!

The Circular Flow Diagram: definition, examples and more!

Claudia Roca

Nov 9, 2022

Nov 9, 2022

Nov 9, 2022

The Circular Flow Diagram: definition, examples and more!
The Circular Flow Diagram: definition, examples and more!
The Circular Flow Diagram: definition, examples and more!

Have you ever asked yourself: where does money come from? 

If you still have no idea how the money cycle works, it's time for you to learn about the circular flow diagram.

Maybe the language of economics sounds like Greek to you... We get it, economists love to use all those complicated words they learned in college.

But there are concepts that can be explained in a very simple way and that's what we'll show you below.

Everything is a cycle: from buying vegetables to receiving your monthly income.

It's time to give value to everything that passes through your hands, because money is a valuable resource that can open the doors of expansion. 

What is the circular flow diagram?

The circular flow diagram is one of the basic concepts of economics.

This diagram explains the general movement of money on a day-to-day basis through the relationship that exists between the main economic agents, such as companies, families and the public sector. 

This way, it works like a cycle where everything comes back to its place. 

How? People all over the world work in companies, these companies pay their salaries, and with that money people buy products and services that satisfy their needs.

Where do you think they make their purchases? Exactly, in companies. So money moves in a kind of loop where it's passed from one hand to another until it reaches its origin. 

The circular flow of income explains both the basic functioning of the economy and its general state, and the higher the flow, the higher the wages people receive, which translates into a greater flow of cash circulating on the streets.

What is the circular flow diagram?

Types of circular flow

It was Francois Quesnay, from France, who developed this concept more than a hundred years ago. He named it after the similarity of the concept with the blood circulation of the human body.  

In this regard, there are two types of circular flow: 

1. Real flow

with the products and services produced in the territory. We could say that it's the result of the work carried out by the different economic agents that exist in a country.

2. Monetary flow

It's the money that goes from one place to the next. This is represented with the circular diagram: it starts with the companies hiring people who, once they receive their salary, give it back to the companies through the purchase of products and services.

So, if you have an accident at home and you need a wrench to fix it, you go to the store and buy it. Well, this wrench represents the real flow, while the monetary flow is the money you pay for the product.

Elements that make up a circular flow

Would you like to know what are the elements that make up one of the most important concepts in economics? Discover them below so that you can understand how this diagram works: 

1. Companies

It's impossible for a country's economy to function if we don't have companies that produce the basic goods that allow us to subsist. That's why many specialists consider companies to be a fundamental indicator of the financial scale of a nation.

At the end of the day, companies generate products, services and jobs for the population, a population that exchanges them for time and workforce, which allows them to obtain money to satisfy their daily needs. 

Thus, we could say that it's the first win-win relationship that ever existed in the story of humanity.

2. Household economies

This is the group of people who have human capital, money, equipment and land and sell them to investors or businessmen to exploit commercially. 

3. Public sector

The government is a key factor in the functioning of the circular flow diagram. 

Its job is to keep the peace for all economic agents and it obtains revenues by collecting taxes. Once they receive the resources, they have the obligation to return it to the population through subsidies, public services, security, infrastructure and economic policies that give stability to the whole country. 

3. Foreign sector

The last element of the circular flow is the foreign sector: since the time of the cavemen, people have realized that they need to work together with individuals from other areas in order to survive.

This is where exports and imports come into play and strongly influence the circular flow of a country's income. 

The plan is for a nation to sell more than it spends

If you think about it, the same thing happens with personal finances. 

Your expenses should always be lower than your income to have financial peace of mind. Thus, if you want to manage a company, a business or even a country, you must first learn to manage your cash flow. 

Elements that make up a circular flow

Why is the circular flow diagram so important in a country's economy?

Do you remember the comparison that the economist Quesnay made with the blood flow of human beings? We can say then, that money is like oxygen for an individual,

Most countries that go into financial crisis have an imbalance in the circular flow of income. In most cases, they have more expenses than income, so the amount of money going into the public funds decreases, which translates into worse public services for society.

This affects companies in one way or another, since no one can permanently isolate themselves from the economic situation. Companies gradually reduce their profits and employees receive, as a consequence, a decrease in their salaries, so they can buy fewer products and services.

In the end, it's a loop that repeats itself endlessly until one of the variants changes its reality. Therefore, you as an entrepreneur should be aware of basic economic indicators such as the circular flow to anticipate possible situations.

How does the circular flow diagram work?

Yes, it's all very nice in theory until you actually see the circular flow diagram of income. Once you get a good look at it, you'll notice a series of arrows and colors that could easily confuse anyone. 

Don't worry, it happens more often than it should...  

That's why we decided to give you a brief explanation of this diagram as you will see it in any basic economics textbook.

  1. A country's economy is made up of companies that produce goods and services

  2. On the right side of the diagram, you will see companies that pay wages to their workers in exchange for work. In addition, companies must also pay landowners through the concept of rent

  3. If necessary, the corporations would have to pay back interest to the banking institutions that lent them money to set up the operations.

  4. On the left side, there are the families who go to the market to offer work, land and capital. In exchange for all this they receive wages, rents and interest.

  5. Later, with the money they receive, they go back to the market to buy the products and services they need for their subsistence. 

  6. This money usually goes into the accounts of companies, who use this capital to finance their operations and pay their payroll for manpower. 

Why should you learn about the circular flow?

So far it's all very nice, but have you ever wondered how important these types of concepts are in your day to day life? 

Here are some of the reasons why you should learn about the circular flow diagram: 

1. You understand how the economy works

We've lost count of the number of entrepreneurs we meet who know next to nothing about economics. Some don't even understand where money comes from, almost as if it fell from the trees. 

If you keep an eye on the circular flow, you will know exactly where the resources come from and the importance of balance in a country's economy. 

2. You detect where the money comes from

For there to be money in your pocket you must give something in return, this is a basic principle of any economic relationship. 

So, the products you see in the market are there thanks to the companies, who in turn benefit from the labor of their workers. In addition, the state provides the guarantees for everyone to perform their labor, while the landowners rent their land so that each corporation works more comfortably. 

It's a never-ending cycle and as an entrepreneur you have to understand it perfectly.

3. You understand the government's economic policies

The government is a key player in the circular flow of income. 

Not only does it generate the policies to perform in the best possible way, but it also develops the taxes that will keep transportation, security and infrastructure in good shape. 

This way, with a little time you will be able to detect the intentions of the current government and thus protect yourself from the consequences of its policies.

Infografía: Why should you learn about the circular flow?

  1. You understand how the economy works

  2. You detect where the money comes from

  3. You understand the government's economic policies

  4. You anticipate problems

Markets where exchanges occur as a result of the circular flow of income.

In previous paragraphs you saw that there are different economic agents that participate in the circular diagram of the economy. Now it's time for you to understand where resource exchanges take place:

1. Products and services market

This is the most common of all and it's the place where families go to buy the products and services they need for their subsistence. 

Here the corporations commercialize the products

It's important to understand that the market is not necessarily a physical place, it can be any place where an exchange between product and money takes place. 

2. Factors of production market

We could call it the labor market. People need to go to companies to offer their labor, time and capital in exchange for money in the form of wages, interest, rents and other benefits. 

Both markets are indispensable for the functioning of the economy, so you should always keep each one in mind. 

Final recommendations about the circular flow diagram 

We know that economics can be an intimidating subject for everyone, and for years we've heard lectures with words that make it difficult to understand. However, today we wanted to get out of that paradigm and give you the information without any of these terms.

The circular flow of income is in the daily life of all of us. 

No matter what you do, whether it's buying an apple or using transportation to get to work, you will always depend on it and it's time to take advantage of all its features.

Now tell us, how do you think the circular flow diagram influences the projection of your business?