[[File:CircularFlowEN.png|thumb|400px|This graph shows the circular cycle of income in a
economy. The flow of money is shown in purple, and the flow of goods and services is shown in orange. Money flows in the opposite direction from goods and services.]]
thumb|360px|right|Basic diagram of the circular flow of income. The functioning of the free-market economic system is represented with [[firms and households and interaction back and forth.]]
The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow analysis is the basis of national accounts and hence of macroeconomics.
The idea of the circular flow was already present in the work of Richard Cantillon. François Quesnay developed and visualized this concept in the so-called Tableau économique. Important developments of Quesnay's tableau were Karl Marx's reproduction schemes in the second volume of Capital: Critique of Political Economy, and John Maynard Keynes' General Theory of Employment, Interest and Money. Richard Stone further developed the concept for the United Nations (UN) and the Organisation for Economic Co-operation and Development to the system, which is now used internationally.
Overview
thumb|360px|Model of the circular flow of income and expenditure
The circular flow of income is a concept for better understanding the economy as a whole and, for example, the National Income and Product Accounts (NIPAs). In its simplest form, the model describes a two-sector economy consisting solely of businesses and individuals, and can be represented by a "circular flow diagram." In this two-sector model, individuals provide the labor that enables businesses to produce goods and services.
These transactions can also be considered in terms of the monetary flows that occur. Businesses provide individuals with income (in the form of compensation) in exchange for their labor, and that income is spent on the goods and services businesses produce. ]]
One of the earliest ideas on the circular flow was explained in the work of 18th century Irish-French economist Richard Cantillon, Cantillon described the concept in his 1730 Essay on the Nature of Trade in General, in chapter 11, entitled "The Par or Relation between the Value of Land and Labor" to chapter 13, entitled "The Circulation and Exchange of Goods and Merchandise, as well as their Production, are Carried On in Europe by Entrepreneurs, and at a Risk." Thornton eds. (2010) further explained:
:Cantillon develops a circular-flow model of the economy that shows the distribution of farm production between property owners, farmers, and workers. Farm production is exchanged for the goods and services produced in the cities by entrepreneurs and artisans. While the property owners are "independent," the model demonstrates the mutual interdependence between all the classes of people that Adam Smith dubbed the "invisible hand" in The Theory of Moral Sentiments (1759). Cantillon distinguished at least five types of economic agents: property owners, farmers, entrepreneurs, labors and artisans, as expressed in the contemporary diagram of the Cantillon's Circular Flow Economy. by which the initial conditions necessary for economic activity to occur are constantly re-created.
Economic reproduction involves the physical production and distribution of goods and services, the trade (the circulation via exchanges and transactions) of goods and services, and the consumption of goods and services (both productive or intermediate consumption and final consumption).
Karl Marx developed the original insights of Quesnay to model the circulation of capital, money, and commodities in the second volume of Das Kapital to show how the reproduction process that must occur in any type of society can take place in capitalist society through the circulation of capital.
Marx distinguishes between "simple reproduction" and "expanded (or enlarged) reproduction". In the former case, no economic growth occurs, while in the latter case, more is produced than is needed to maintain the economy at the given level, making economic growth possible. In the capitalist mode of production, the difference is that in the former case, the new surplus value created by wage-labour is spent by the employer on consumption (or hoarded), whereas in the latter case, part of it is reinvested in production.
Further developments
thumb|The competitive price system adapted from [[Paul Samuelson|Samuelson, 1961]]
An important development was John Maynard Keynes's 1933 publication of the General Theory of Employment, Interest and Money. Keynes' assistant Richard Stone further developed the concept for the United Nations (UN) and the Organisation for Economic Co-operation and Development to the systems, which is now used internationally.
The first to visualize the modern circular flow of income model was Frank Knight in 1933 publication of The Economic Organization. Knight (1933) explained:
:[we may view the] economic organization as a system of prize relations. Seen in the large, free enterprise is an organization of production and distribution in which individuals or family units get their real income, their "living," by selling productive power for money to "business units" or "enterprises", and buying with the money income thus obtained the direct goods and services which they consume. This view, it will be remembered, ignores for the sake of simplicity the fact that an appreciable fraction of the productive power in use at any time is not really employed in satisfying current wants but to make provision for increased want-satisfaction in the future; it treats society as it would be, or would tend to become, with progress absent, or in a "static" state.
Knight pictured a circulation of money and circulation of economic value between people (individuals, families) and business enterprises as a group, explaining: "The general character of an enterprise system, reduced to its very simplest terms, can be illustrated by a diagram showing the exchange of productive power for consumption goods between individuals and business units, mediated by the circulation of money, and suggesting the familiar figure of the wheel of wealth."
Types of models
A circular flow of income model is a simplified representation of an economy. (Some sources refer to households as "individuals" or the "public" and to firms as "businesses") The model assumes that there is no financial sector, no government sector, and no foreign sector. In addition, the model assumes that (a) through their expenditures, households spend all of their income on goods and services or consumption and (b) through their expenditures, households purchase all output produced by firms.
Three-sector model
thumb|Three-sector circular flow diagram
The three-sector model adds the government sector to the two-sector model. (The foreign sector is also known as the "external sector," the "overseas sector,"
- Measurement of national income
- Knowledge of interdependence – the circular flow of income signifies the interdependence of each of the activities upon one another. If there is no consumption, there will be no demand and expenditure, which in fact restricts the amount of production and income.
- Unending nature of economic activities – signifies that production, income, and expenditure are of an unending nature; therefore, economic activities in an economy can never come to a halt. National income is also bound to rise in the future.
- Injections and leakages
Circular flow diagram as a subsystem of the environment
thumb|upright=1.2 |The economic system as a subsystem of the environment: natural resources flow through the economy and end up as waste and pollution.
The circular flow diagram is an abstraction of the economy as a whole, which suggests that the economy can reproduce itself. It shows that as households spend money on goods and services from firms, the firms have the means to purchase labor from the households, and this labor is used to produce the goods and services that households can then purchase. The model suggests that this process can and will continue as a perpetual motion machine.
However, according to the laws of thermodynamics, perpetual motion machines are not possible. The first law states that matter and energy cannot be created or destroyed, and the second law states that matter and energy move from a more useful state of low entropy (order) to a less useful state of higher entropy (disorder). Thus, no system can continue without new inputs of energy, which then exit as high-entropy waste. Just as no animal can live on its own waste, no economy can recycle the waste it produces without the input of new energy to reproduce itself. The economy therefore cannot operate on its own, but must operate as a subsystem within a larger ecosystem.
While the circular flow diagram is useful in understanding the basics of an economy, such as leakages and injections, it does not fully address the economy's reliance on natural resources and the creation of waste that must be absorbed in some manner. The economy can only continue functioning if it has the matter and energy to power it, and the ability to absorb the waste it creates. This matter and low entropy energy, and the ability to absorb waste, exist in a finite amount. Thus, there is a finite amount of inputs to the flow and outputs of the flow that the environment can handle, implying there is a sustainable limit to motion and therefore the growth of the economy.