The circular flow model describes movement of resources, goods and services in the economy, providing an overview of the market system and demonstrating the interconnectedness of the different economic sectors. While the model is simple, it can be easily expanded by adding more sectors.
The Circular Flow in Action
In its simplest form, the circular flow model includes two sectors -- Households and Business. The households control all the resources -- land, labor, capital and entrepreneurship -- which they sell to the businesses, receiving payment in the form of rent, wages and salaries, interest and profit. Those transactions occur in the Resources Market. With their earned income, the households purchase goods and services from the businesses in the Product Market, providing businesses with the income to employ the resources from the households. If households fear the onset of a recession, then they start to save money, which is considered a leakage in the system. With a reduced flow of income coming from the sale of goods and services, the business sector is forced to employ fewer resources, and the result is a rise in unemployment. The solution is to introduce a third sector, the Banks, which lend the saved money to businesses, injecting the money back into the flow.