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.Antoin E. Murphy. "John Law and Richard Cantillon on the circular flow of income." Journal of the History of Economic Thought. 1.1 (1993): 47–62. François Quesnay developed and visualized this concept in the so-called Tableau économique.Backhouse, Roger E., and Yann Giraud. "Circular flow diagrams." in: Famous Figures and Diagrams in Economics (2010): 221–230. Chapter 23. 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

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.Measuring the Economy : A Primer on GDP and the National Income and Product Accounts , by Bureau of Economic Analysis (BEA), U.S. Department of Commerce, October 2014.

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.

The circular flow diagram illustrates the interdependence of the "flows," or activities, that occur in the economy, such as the production of goods and services (or the "output" of the economy) and the income generated from that production. The circular flow also shows the equality between the income earned from production and the value of goods and services produced.

The world economy is more complex than this two-sector model, and involves interactions between not only individuals and businesses, but also federal, state, and local governments and residents of the rest of the world. There are also other aspects of economic activity such as investment in capital (produced—or fixed—assets such as structures, equipment, research and development, and software), flows of financial capital (such as stocks, bonds, and bank deposits), and the contributions of these flows to the accumulation of fixed assets.

History

Cantillon

One of the earliest ideas on the circular flow was explained in the work of 18th century Irish-French economist Richard Cantillon, who was influenced by prior economists, especially William Petty.Aspromourgos, Tony. "'Political economy and the social division of labour: the economics of Sir William Petty." Scottish Journal of Political Economy 33.1 (1986): 28–45. 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 2010, p. 69: Abstract of chapter 12. 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.

Quesnay

François Quesnay further developed these concepts, and was the first to visualize these interactions over time in the so-called Tableau économique. Quesnay believed that trade and industry were not sources of wealth, and instead in his 1758 book Tableau économique (Economic Table) argued that agricultural surpluses, by flowing through the economy in the form of rent, wages, and purchases were the real economic movers, for two reasons. First, regulation impedes the flow of income throughout all social classes and, therefore, economic development. Second, taxes on the productive classes, such as farmers, should be reduced in favor of higher taxes for unproductive classes, such as landowners, since their luxurious way of life distorts the income flow. The model Quesnay created consisted of three economic agents: The "Proprietary" class consisted of only landowners. The "Productive" class consisted of all agricultural laborers. The "Sterile" class is made up of artisans and merchants. The production and/or cash flow between the three classes started with the Proprietary class because they own the land and they buy from the other classes. Quesnay visualised the steps in the process in the Tableau économique.

Marx In Marxian economics, economic reproduction refers to recurrent (or cyclical) processesIn a recurrent process, the same event repeats itself on multiple occasions. In a cyclical process, a sequence of events repeats itself on a regular basis. by which the initial conditions necessary for economic activity to occur are constantly re-created.Michel Aglietta, introduction to Aglietta, A theory of capitalist regulation. London: NLB, 1979.

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.Karl Marx, Capital, Volume II. Penguin Classics, 1992.

Marx distinguishes between "simple reproduction" and "expanded (or enlarged) reproduction".Karl Marx, Capital, Volume I. Penguin Classics, 1990, chapter 23 and Capital, Volume II. Penguin Classics, 1992, chapter 20 and 21. 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

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.Frank Knight. The Economic Organization, 1933. pp.59-60

Knight pictured a circulation of money and circulation of economic value between people (individuals, families) and business enterprises as a group,Knight (1933, p. 61) 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."Knight (1933, p. 60)

Types of models A circular flow of income model is a simplified representation of an economy.

Two-sector model

In the basic two-sector circular flow of income model, the economy consists of two sectors: (1) households and (2) firms. (Some sources refer to households as "individuals" or the "public" and to firms as "businesses" or the "productive sector.") 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. This means that all household expenditures become income for firms. The firms then spend all of this income on factors of production such as labor, capital and raw materials, "transferring" all of their income to the factor owners (which are households). The factor owners (households), in turn, spend all of their income on goods, which leads to a circular flow of income.

Three-sector model

The three-sector model adds the government sector to the two-sector model. Thus, the three-sector model includes (1) households, (2) firms, and (3) government. It excludes the financial sector and the foreign sector. The government sector consists of the economic activities of local, state and federal governments. Flows from households and firms to government are in the form of taxes. The income the government receives flows to firms and households in the form of subsidies, transfers, and purchases of goods and services. Every payment has a corresponding receipt; that is, every flow of money has a corresponding flow of goods in the opposite direction. As a result, the aggregate expenditure of the economy is identical to its aggregate income, making a circular flow.

Four-sector model