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Mini essay: CIRCULAR FLOW MODEL "Explain the circular flow model....

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Mini essay: CIRCULAR FLOW MODEL "Explain the circular flow model. What assumptions is it based upon? How is equilibrium determined in the model? Explain its application in the real world."

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  • June 12, 2008
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The circular flow of income model is a theoretical representation of the economy. It shows the distribution of income within the economy and the interaction between the different sectors in a modern market economy. The five-sector model is a more elaborate model in comparison to the basic, two, three and four sector models. The model represents an economy like Australia and divides the economy into five main sectors.

The first sector in the model is the Households sector. This sector refers to all individual members in the economy. All individuals of an economy are consumers. Consumers are concerned with earning an income for themselves and spending on goods and services. Households supply factors of production i.e. land, labour, capital and enterprise and are rewarded with income in the form of rent, wages, interest or profit by the firms sector.

The second sector in the model is the Firms sector. This sector represents all of the business firms involved with the production and distribution of goods and services. Firms contribute to the circular flow as it is in a business's best interest to obtain factors of production and use them to produce and sell goods and services.

The basic model is based on the assumption that the economy consists of only the Households and Firms sectors. Here, the model is overly and rather, unrealistically simplified so the consideration of the other sectors is absent. In this model, leakages and injections do not exist. It does not take into account the capital market, where savings by consumers and investment by firms are leakages and injections respectively. It also assumes that there is no government sector influencing the economy, meaning consumers pay no taxes as businesses do not receive any benefits nor do consumers receive any social security payments. The basic model also does not take into consideration the overseas sector. So the model assumes there are no imports and no exports i.e. it is a closed economy.