The simple circular flow of the economy

In “Economic activity: households, businesses and the state”, you learnt about the three participants in the economy: households, businesses and the state. Now we will take a closer look at how the first two interact. Economists use a model to do this: they leave out anything that is not important for the moment. The state is deliberately left out for now; it returns in “The extended circular flow of the economy: the state, banks and the rest of the world”. That leaves households and businesses, with things constantly flowing back and forth between them.

Think again about your holiday job at the bakery: for a month, you supply the bakery with your labour, stocking shelves and serving customers. At the end of the month, the bakery transfers your wages to you. The next day, you buy a sandwich there: the bakery gives you a good, and you pay for it at the till.

Four things have flowed: your labour, your wages, the sandwich and your money. Two are something 'real', and two are money. In each exchange, they move in opposite directions. These four flows make up the simple circular flow of the economy.

The simple circular flow of the economy consists of two exchanges you already know from “Economic activity: households, businesses and the state”. What is new is how we look at them: we draw them as flows between households and businesses.

Exchange 1: Work for wages

• Households supply businesses with labour: people work in bakeries, shops and offices.
• Businesses pay households wages in return: the money flows in the opposite direction, from the business to the household.

Exchange 2: Goods for money

• Businesses supply households with goods and services: bread, a sandwich, a haircut or a bus journey.
• Households pay for them: their consumer spending flows to the business, again in the opposite direction.

Can you spot the pattern? Every exchange consists of two flows moving in opposite directions: something 'real' flows one way, and money flows the other way. Together, the four flows form a closed loop. Take a look at the diagram.

Look closely at the four arrows in the diagram. Two carry something 'real', and two carry money:

• Real flow (also called the flow of goods and services): the labour supplied by households and the goods and services supplied by businesses. This flow includes everything that directly provides a benefit: work, bread or a haircut.
• Money flow: the wages paid by businesses and the consumer spending of households. This is the money used to pay for what is supplied in the real flow.

The key point is that the two flows move in opposite directions. Every real-flow arrow has a corresponding money-flow arrow pointing the other way. Check this using the example: the sandwich moves from the bakery to you (real flow), while your money moves from you to the bakery (money flow). Your labour goes from you to the bakery (real flow), while your wages go from the bakery to you (money flow).

Watch out for a common misconception: 'Wages belong to the real flow because they are a reward for real work.' That is incorrect: what matters is what flows, not what it pays for. Wages are money, so they belong to the money flow. The labour they pay for belongs to the real flow. And remember: services also belong to the real flow, even though you cannot touch them. A haircut is a real service, not money.

Why draw all this as a circular flow instead of a list of exchanges? Because the flows never stop, and the same money keeps changing hands.

Follow your wages one step further: the bakery transfers your wages to you. For the bakery, this is spending; for you, it is income. You use some of it to buy a sandwich. Now it is the other way round: for you, the purchase is spending; for the bakery, it is income. The bakery uses this income to pay wages again, perhaps even yours. The money has not disappeared or been used up: it circulates.

This gives us the central rule of the circular flow: One participant's spending is another's income. There is no beginning and no end; each flow sets the next one in motion. This is why households and businesses depend so closely on each other: if households buy less, businesses receive less income and can pay less in wages, which could in turn mean households spend less.

One final point to keep in mind: our circular flow is a simplified model. You will explore what happens when the state joins in again in “The extended circular flow of the economy: the state, banks and the rest of the world”.