An economy is a complex system and it is impossible to model or even describe all the different forces that has an impact on the level of economic activity. To understand what determines the level of economic activity, we need to simplify things by focusing on the most important forces that shape an economy.

The circular flow model is a simplification of how the economy works. In a complete circular flow model, the interaction and interdependence between the major participants (households, firms, government and the foreign sector) in the various markets (factor, goods and financial) are captured and explained.

You will learn how the decisions these participants make and the way in which they interact have an impact on the economic life of every individual in our society. You will also see how the decision of one participant in the economy impacts on and elicits a reaction in the behaviour of another participant, and the influence this has on the level of economic activity.

In this section, we consider a model that includes only two participants: households and firms, and two markets: the goods and factor markets.