Living Economics: The Expanded Circular Flow Diagram

The Circular Flow Diagram as we discussed before (“Basic Circular Flow Diagram”) depicts the national economy — the parties, the markets, and how they interact.

The basic model depicts the simplest of all market economies:

  • Two Actors: Households and Firms
  • Two Markets: Market for Factors of Production and Market for Finished Products
  • Two Circles depicting the trade that moves resources throughout the economy: Money and Resources

This model is perhaps overly simplified and becomes increasingly complex as other parties and transactions form.

1) Government

In addition to households and firms, most economies incorporate governmental actors (some larger and more involved than others).

The government is generally involved at all levels through its own transactions with households, firms, and the two markets. Remember the government is both a producer of social resources and a consumer of resources.

The government provides innumerable resources to households and firms ranging in everything from highways and libraries to welfare and military defense. In return, households and firms provide tax revenue to the government in a variety of forms.

The government also offers several finished goods and services in the market through SEOs and nationalized industries (e.g. utilities, banking services).

Conversely, the government purchases or receives substantial labor and capital from the market for factors of production.

Generally resources the government receives are known as revenue and the resources the government spends are known as expenditures.

2) B2B | H2H – Business to Business & Household to Household

Students of economics often point out a rather glaring flaw in the diagram wherein not all trade is between Households and Firms.

A substantial amount of trade within the economy revolves around B2B or Business to Business transactions where one firm (e.g. supplier) sells finished goods or unfinished goods to another firm (e.g. manufacturer). Firms themselves buy a substantial amount of resources in the market for finished products.

On the other end, not all households are selling factors of production to firms. There are innumerable situations wherein one private citizen sells labor or trades resources with another private citizen. This includes anything from babysitting to mowing the yard.

Consequently, each market becomes more complex if looking at the internal movement of resources. That said the general theory of the trade usually still applies (Money traded for Resources)

3) Financial Markets

An increasingly significant market is the financial market were money is traded specifically for other currencies or financial profits. This market does not meet the Resources ⬌ Money nature of the rest of the circular flow diagram, but is substantial and includes all of the aforementioned actors (firms, households, governments).

Generally, this market adopts a Money ⬌ Money system wherein money from one currency is then traded for money in other currencies. Or where money is traded as an investment for greater future monetary profits.

Banks, Lenders, and Currency Traders all fit into this category.

Money Traders operate identically to any other company with a product to sell (Currency A) and a buyer interested to trade (Currency B). There are factors of production (Capital, Land, Labor) and Finished products.

Banks and Lenders operate in within their own system, carefully funneling money to households and firms and the government as is needed to manage the circular flow diagram. They monitor and manage the “money” circle of the system.

4) Foreign Markets

With the rise of the Global Economy, countries have also begun expanding the market to external forces. Namely through imports (Households and/or Firms trading money for resources from abroad) and exports (Households and/or Firms trading resources for money).

The impact of foreign trade appears in both the Market for Goods and Services and in the Market for Factors of Production. FDI (Foreign Direct Investment) for example is often money spent in the market for factors of production (capital, labor, land, etc).

Clearly the actual economy is much larger than a simple system of households and firms; but the basic concept remains the same regardless of who the people involved are. There is always a trade of Resource A for Resource B. . . . the more satisfied each party is, the more they trade in the future and the more happiness the system produces

State Companies
Industries owned and operated by the federal government.
B2CBusiness to Consumer
A transaction of finished goods shifting from the firm to the household.
B2BBusiness to Business
A transaction of finished or unfinished goods shifting from one firm to another.
Government RevenueResources the government receives through the economic system
Government ExpendituresResources the government spends on its operations or through contributions to the country’s welfare
ImportsResources purchased from foreign sellers and brought into the country
ExportsResources produced inside the country and sold to foreign consumers.

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