Circular Flow of Income
An economic model showing how money flows between households and firms through product and factor markets.
What is Circular Flow?
The circular flow of income is a macroeconomic model illustrating how money continuously moves through an economy between households and firms. In the simple two-sector model, households supply labor and capital to firms (factor markets) and receive wages and profits in return; they then spend that income on goods and services produced by firms (product markets). The model expands to include the government sector (taxes and government spending), the financial sector (savings and investment), and the foreign sector (exports and imports). Injections — investment, government spending, and exports — add to the circular flow, while withdrawals — saving, taxes, and imports — remove money from it. Equilibrium occurs when injections equal withdrawals.
Example
When the U.S. government increased fiscal stimulus payments in 2020–2021, it injected additional money into the circular flow: households received direct payments, spent them on goods and services (boosting firm revenues), which paid wages to workers (boosting household income again). The multiplier effect amplified this initial injection, with economists estimating a fiscal multiplier between 0.8 and 1.5 for direct payments.