Introduction

Now that we have identified two main participants in the economy, namely households and firms, and two markets, namely the factor and goods markets, we can design a model to show the interactions between firms and households through the goods and factor markets.

The circular flow model that we will build consists of two participants, namely households and firms, and two markets, namely the factor market and the goods market and two kinds of flows namely nominal (monetary flows) and real flows.

Simple circular flow model with two participants and two markets

Simple circular flow model with two participants and two markets

Simple circular flow model with two participants and two markets

Simple circular flow model with two participants and two markets

Simple circular flow model with two participants and two markets

After you have worked through this section of the learning unit, you should be able to use the circular flow model to illustrate and explain:

  • the interdependence between households and firms
  • the real and nominal (monetary) flows through the factor market and the goods market
  • the impact of a change in a flow

Flows between households and firms through the factor market

From households to firms, there is a flow of factors of production through the factor market, as illustrated by the dotted line. This is a real flow. An example of this flow would be you leaving your house in the morning to go to work at a firm. This is an example of a real flow of labour. Then there is also the flow of capital, land and entrepreneurs from households to firms. This real flow of the factors of production takes place through the factor market.

Flows through the factor market

Flows through the factor market

Flows through the factor market

From firms to households, there is an income flow through the factor market as firms pay households for the use of the factors of production owned by households, as indicated by the solid line. This is a monetary flow. An example of this flow would be you receiving payment in the form of a wage by the firm you are working for. Rent for land, interest for capital and profits for entrepreneurs are all nominal (monetary) flows and part of the income flow.

Flows between firms and households through the goods market

Firms use the factors of production to produce goods and services that they make available to households through the goods market. This is the real flow of goods and services from firms to households, and it is indicated by the dotted line. An example of this flow would be the actual groceries you buy from, say, your local supermarket.

Flows through the goods market

Flows through the goods market

Flows through the goods market

Households use their income to pay for the goods and services they receive from firms. This payment for goods and services is a monetary flow from the households to firms through the goods market (indicated by the solid line, and it is the spending flow. An example of this flow would be when you pay for your groceries.

COMPLETE CIRCULAR FLOW

Economic growth in South Africa

We can therefore distinguish between two kinds of flows between households and firms, namely real flows and nominal (monetary) flows through the factor market and the goods market. Notice how the nominal (monetary) flow is in the opposite direction of the real flow.

Impact of a change in a flow

We can now use this model to explain what happens to the flows if, for instance spending by households increases:

  • As spending by households increases, the monetary flow from households to firms increases through the goods market.
  • As the goods move from firms to households, the real flow from firms to households increases.
  • This increased spending by households causes firms to increase production since the demand for goods is higher. As firms increase production, the production flow increases and more factors of production are employed.
  • There is thus an increase in the income flow from firms to households through the factor market.

Watch the following video clip on the impact on the change in a flow

Activity

Do the following activity on the circular flow:

Choose the correct term in brackets:

As production by firms decreases, the (monetary flow, real flow) of factors of production from households to firms (increases, decreases) through the (goods market, factor market). As a result, the monetary flow to households (increases, decreases) since the income flow is (greater, smaller) from firms to households. This change in the income flow causes the spending flow by households through the (goods market, factor market) to (increase, decrease). This, in turn, causes the (monetary flow, real flow) of goods and services between firms and households to (increase, decrease).

Click to see the answer

As production by firms decreases, the real flow of factors of production from households to firms decreases through the factor market. As a result, the monetary flow to households decreases since the income flow is smaller from firms to households. This change in the income flow causes the spending flow by households through the goods market to decrease. This, in turn, causes the real flow of goods and services between firms and households to decrease.