Circular Flow Model

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The circular flow model reflects the flow of money, goods and services throughout the economy. This model is composed of households and business firms and it divides the markets into two categories, Product Market and Factor Market. In the Product Market, the households consume and purchase the goods and services that are sold by the business firms, creating exchange of currency (dollars) between the households who are receiving a finished product and the business firms who are making a profit. If the circular flow model did not have the Factor Market to complete the circular cycle, all the money in the economy would be kept by businesses and all the finished products would be kept by households. This would put a stop to the economy. The Factor Market completes the flow of money in which the role of households and firms is switched compared to the Product Market. In order to have a finished product, firms require labor, capital, real estate and more. Households can be thought of as sellers in this case as they provide the labor, capital and other factors of production to firms. In exchange for the use of factors of production, firms compensate households with salaries and wages. As the Product Market and Factor Market combines, a closed loop of the flow of money becomes evident. The loop allows the flow of income, preventing the households or business firms to keep all of the money which results in continued economic activity that is sustainable in the long run. It is important to note that firms use factors of production to produce finished products which households consume in order to provide factors of production. The government also plays a key role in the circular flow model by intervening between firms, households and the markets. The government collects taxes from households which reduces the expenditures on goods and services. The government also regulates and collects taxes from firms. The collection of taxes funds government spending which can be...
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