Circular Flow Diagram
Circular flow diagram shows how income flows in an economy between households, firms and government in product markets, factors of production markets and financial markets.
An economy is all about satisfying the coincidence of wants of different people. Because we aren’t self-sufficient, we specialize in activities in which we are best at. We sell our goods and services at which we excel to others for money which we use buy theirs in return. We pay taxes to government out of our income which it uses to provide us with public goods and services, etc. The circular flow diagram lets us visualize all these transactions between different market participants.
Important actors in the circular flow of income are (a) households, (b) firms and (c) government. Households provide labor, capital and savings while firms provide goods and services. Federal, state and local governments they collect taxes from households and firms and provide public goods and services.
There are three major types of markets: (a) the factors (of production) market, (b) the products and services market and (c) the financial market.
Production by firms requires inputs i.e. factors of production, primarily labor and capital, which is provided by households in the factor (of production) market. Labor is compensated through wages and capital is paid in the form of interest (if it’s a debt capital) and profit/dividends (if it is equity capital). The factors of production market involves flow of income/money from firms to households.
Goods and Services Market
The products and services produced using those inputs are bought by households in the market for goods and services (also called products market). Firms supply goods and services which consumers pay for with the income they earn in the factor market. The product market shows flow of income from households to firm.
The financial market is the market in which households invest their savings and firms raise money for their long-term investments. The financial market has a very important supporting role for products market. Without mobilization of private and public savings, firms may not be able to improve their productive capacity or improve productivity.
The financial market involves transfer of money initially from households to firms which pay it back in the form of interest and principal and dividends.