-An economy is analogous to a complex machine; there are a lot of moving parts, many of which depend on each other. If one part breaks down, then the whole machine breaks down.
-This concept can easily be seen in the circular flow model.
-To keep things simple, we’ll look at a private closed economy so there are only two parts: households (consumers) and businesses (firms).
-There are two types of flows in this model: real flows (goods, services, and resources) and monetary flows (money).[break]
-Starting with households: Households are the keepers of resources (land, labor, capital, and entrepreneurial ability). They offer up their resources for use in the resource market.
-Businesses take the resources from the resource market and transforms them into goods and services, which they offer up in the product market.
-Households consume the goods and services from the product market.[break]
-Opposite of the real flows are the monetary flows, which is money that gets exchanged for the goods, services, and resources.
-Households spend their money in the product market to consume goods and services (consumption expenditures).
-The money that businesses get from offering goods and services in the product market is known as revenue.
-Businesses take the revenue that they get to pay for the costs of buying resources from the resource market.
-The money that is spent by businesses in the resource market translate into income for households.[break]
Circular Flow Diagram
-Combing the two together gives you the circular flow diagram. With this you can easily see how one part of the economy is dependent on the other.
-For example, if households consumed less goods and services then businesses won’t make as much revenue which leads to them purchasing fewer resources which means less income for households which means fewer goods and services are consumed, so on and so forth.
-The opposite is also true: increased spending in one part would lead to increased spending in the other, cycling back and forth.
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