Circular Flow of Money

You may have heard the popular saying, "what goes around, comes back around". It's overused, we know... But, we had to repeat it once more because it applies to money. The circular flow of finance basically covers how money goes around and comes back around. Now, you may be thinking that this is good news, since all the money you have ever spent will come back to you eventually. Oh, wouldn't that be sweet! Sadly, your money isn't coming back to you. However, what's coming to you is this explanation on the circular flow of finance which shows how money travels in a circle between households, businesses, and the government. Read on, you'll love it!

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Contents
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    Circular Flow of Money Definition

    The definition for the circular flow of money can be taken from its name. It is the economic model that describes the looped flow of money in the network of consumers and producers in an economy. All this is saying is that the money leaves the hands of the consumers and goes to the producers. It then leaves the hands of the producers and goes to the consumers, and this cycle continues infinitely.

    The circular flow of money describes the looped flow of money in the network of consumers and producers in an economy.

    The Circular Flow of Finance The circular flow of money StudySmarterThe circular flow of money, pixabay

    Circular flow of money explanation

    So, the circular flow of money describes how money travels in a loop between consumers and producers. But what does this mean? You're a consumer, so you should be able to describe exactly how you participate in the circular flow of money. Well, let's explain things with a quick example.

    You buy a can of Red Bull for $4. You work in a shoe manufacturing company, and you get paid $40 an hour.

    From this simple example, you're the consumer and Red Bull and the shoe manufacturing company are the producers. So, when you bought the can of Red Bull, money left your hands and went to Red Bull. Then, when the shoe manufacturer pays you, money has left the producer's hands to you. You won't stop consuming, and the producers will not stop producing, so money will always be traveling in circles between you and the producers. That's it! It is that simple.

    Now, let's get to the details because what we have said so far is what you will tell your friends who are not economists.

    In the circular flow of money, every economy has three main actors. These actors are the savers, investors, and financial institutions.

    The circular flow of money involves a network of savers, investors, and financial institutions.

    There are three key parts in the financial system. The first part involves the funds savers save by transferring them to a borrower. The second part is financial assets used to certify the conditions of the loan. The third and final part involves the organizations that link the surplus funds with the financial assets.

    Note that the financial assets are things like the receipts, deposit certificates, bonds, etc. Anything that certifies that you own the funds you just deposited.

    For savers to be able to lend funds to borrowers, they need financial intermediaries. These are organizations we normally know as banks, insurance companies, and other similar organizations. Financial intermediaries are necessary because as a lender, it can be hard to find someone who needs exactly how much you want to lend. The financial intermediaries take care of all this by managing the lending and borrowing - all you have to do is to deposit your funds!

    Learn more in our article - Financial Intermediaries!

    Circular Flow of Money Diagram

    Economists illustrate the circular flow of money using the diagram shown in Figure 1. You can call this diagram the circular flow of money; it has the same name as the concept it describes. As you can see, we have households and businesses on the left and governments, and businesses on the right with financial intermediaries in the middle.

    Households include consumers and employees who get paid wages, pay for goods, or save. Businesses are also on the left because they give loans or save. On the right side, the government and businesses receive the loans and invest them, paying them back to the households and businesses. So, the cycle continues as the left side receives money and saves that money with financial intermediaries.

    The circular flow of money diagram depicts the looped flow of money in the network of consumers and producers.

    Circular Flow of Money Importance

    Why is the circular flow of money important? Simple, money is the value placed on resources and products in an economy. Therefore, the circular flow of money enables consumers and producers to transact with each other in an economy.

    The circular flow of money enables consumers and producers to transact with each other in an economy.

    Let's look at an example.

    Consider an economy where consumers work on a farm. The farm supplies food items to a restaurant, who then makes food to sell to the consumers.

    Now, if the consumers refuse to buy food from the restaurant, it goes out of business. As a result, nobody buys from the farm and the farm also goes out of business. Then the consumers don't get paid anymore because the farm is out of business. See? Money simply must move around!

    The circular flow of money keeps an economy going because as money changes hands, the money creates extra value and keeps the economic system going.

    Circular Flow of Money types

    The circular flow of money can be between the two sectors of households and businesses.

    It can also be between three sectors, including households, businesses, and the government.

    Lastly, it can be between four sectors, and this includes households, businesses, the government, and the rest of the world.

    Just keep the household, businesses, and the government (three sectors) in mind at this level.

    Circular Flow of Money - Key takeaways

    • The circular flow of money describes the looped flow of money in the network of consumers and producers in an economy.
    • The circular flow of money involves a network of savers, investors, and financial institutions.
    • The three phases of the circular flow of money include the transfer of money from savers, the second part involves the financial assets to certify the loan, and the third involves linking the surplus finds with the financial assets.
    • The circular flow of money diagram depicts the looped flow of money in the network of consumers and producers.
    • The circular flow of money enables consumers and producers to transact with each other in an economy.
    Frequently Asked Questions about Circular Flow of Money

    What is circular flow of money in economics?

    The circular flow of money describes the looped flow of money in the network of consumers and producers in an economy.

    Why is the circular flow of money important?

    The circular flow of money enables consumers and producers to transact with each other in an economy.

    What are the phases of circular flow of money?

    There are three key parts in the financial system. The first part involves the funds savers save by transferring them to a borrower. The second part is financial assets used to certify the conditions of the loan. The third and final part involves the organizations that link the surplus funds with the financial assets.

    What are the types of circular flow?

    The circular flow of money can be between the two sectors of households and businesses. It can also be between three sectors, including households, businesses, and the government. Lastly, it can be between four sectors, and this includes households, businesses, the government, and the rest of the world.

    How do you explain a circular flow diagram?

    It shows households and businesses on the left and governments, and businesses on the right, with financial intermediaries in the middle. Households include consumers and employees who get paid wages, pay for goods, or save. Businesses are also on the left because they give loans or save. On the right side, the government and businesses receive the loans and invest them, paying them back to the households and businesses.

    Test your knowledge with multiple choice flashcards

    Investors are the borrowers.

    A strong financial system does not really need the circular flow of money.

    Financial intermediaries come before savers in the circular flow of money.

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