Circular flow of income: What essential functions does it fulfil in the economy?

If there is a concept that explains and simplifies how the economic system in which ordinary citizens live works, it is the term circular flow of income. If you have not yet heard of it, keep reading this post because we are going to see what it consists of, the types there are, the factors that influence these economic movements and the importance it has for family income.

Let’s start by defining what the circular flow of income is.

Circular income flow is an economic concept that describes the continuous movement of income and expenses within an economy. This flow represents the interaction between households and companies through the purchase and sale of goods or services. It is based on a simplified model that shows how households receive income from their work (salaries, rents, benefits, etc.) from companies in exchange for the services they offer and, in turn, how households use that income to purchase goods and services produced by companies. These entities, in turn, obtain income from the sale of their goods and services to households, thus closing the economic cycle.

The circular flow of income illustrates the way in which resources and money constantly circulate in an economy, generating income and employment as the production and consumption process is completed.

Why is it important to understand how the circular flow of income works?

If you have ever wondered what your role is within the economic system, studying the functioning of the circular flow of income will help you find your place. Get the idea that each of us is part of an essential gear for the circle that, broadly speaking, is based on the model of supply and demand.

Imagine that the economy is like a big cycle in which we are all connected. Companies give us jobs, and in return, we give them our effort and time to produce things. They pay us for our work, and with that money, we buy things we need or want. That purchase makes companies sell more and thus the cycle continues.

Furthermore, this flow shows us how money and resources move from one place to another. For example, when we pay taxes, that money goes to the government and is then used to build schools, hospitals, or roads. It also shows how countries exchange goods with other countries: what we export and what we import. All of this affects the economy, employment and how we live.

Types of circular income flows

Economics divides circular income flows, which represent how the different parts of an economy are related, showing the continuous movement of income and expenses between households, businesses and government.

Simple circular flow

This type of flow refers to a basic economic model that shows the relationship between families and companies. In this flow, companies provide goods and services to families, who pay for those goods and services with the money they receive as income from the companies for their work. This simplified model does not include the government or the external sector.

Expanded or complex circular flow

In this case, the simple circular flow model is expanded to include the government and the external sector (exports and imports). This model represents how families receive income from businesses for their work, pay taxes to the government, receive transfers from the government, purchase goods and services from businesses (including the government as a consumer), and also interact with the rest of the world through the export and import of goods and services.

What factors intervene in the circular flow of income and what function does each one play?

The factors that we explain below play a specific function and interact with each other to keep the machinery in balance.

• Families or households: represent people who work and offer their labour to companies in exchange for salaries, benefits or income. Its main function is to provide work and receive income from it.
• Companies: are the productive units that employ people to produce goods and services. They pay wages and other income to families for their work and sell products to families, earning income in return.
• Government: intervenes by collecting taxes from families and companies and, in turn, spending that money on public goods and services such as education, health, infrastructure, among others. It also provides economic transfers to families (such as subsidies) that can influence their consumption capacity.
• External sector: includes economic transactions with other countries, that is, exports (selling goods and services abroad) and imports (buying goods and services from abroad). Exports generate income and imports imply outflows of money abroad.

You can also read about the following topics:

• Did you know that maintaining a positive attitude at work increases productivity by 12%?
• Discover 5 examples of Corporate Social Responsibility