Introduction to Economics

The Circular Flow Diagram

Economists use a variety of models to help them to explain the activity which they can see in the economy. The simplest of these models is called the circular flow diagram. Although it is a relatively simple model, you will find that you can use it to help you to explain some of the most sophisticated interactions that are seen in the economy. It looks like this:

This diagram can tell us a great deal about the consequences of some of the decisions that we make.

For example, imagine a situation in which we were lucky enough to receive an increase in our pay. While we might save some of that money, it is also possible that we will spend some of that money. In other words, an increase in income will result in an increase in spending.

When that happens, we will be spending our money on goods and services. This means that those products need to be available for sale. If enough people are willing to spend more money, then the level of production will need to increase. The extra income that we received has now resulted in an increase in production.

But if that happens, then more people will be needed to create those goods and services. If we are going to produce more, then we might need to employ more people. If that happens then it is reasonable to assume that these people will be receiving an income. As they are now earning money, they will start spending more.

The reverse is also true. For example, if tax rates were to increase, then we will have less money to spend. When that happens production levels could fall, and this might mean that some people lose their jobs.

While this model is very useful, it also has some limitations. For example, earlier we suggested that when people receive more money in income they might choose to save some of it. What happens to the money that is saved? To understand the consequences of that decision, we will need to expand on this model.

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