The circular flow model implies a complex, interrelated web of decision making and economic activity. In monetary economy, there are two decision makers; households and businesses. Government is added as a third decision maker in open economy.
Households and
businesses participate in both basic markets, resource and product market, but
on different sides of each. Businesses are on the buying or demand side of
resource markets and households, as resource owners, are on the selling or
supply side. In the product market, these positions are reversed. Households,
as consumers, are on the demand side, and businesses are on the supply side.
The interaction of
firms and households in product and factor markets generates a flow of
expenditure and income. Factor services are sold by households through factor
markets. This leads to a flow of income from firms to households. Commodities
are sold by firms through product markets. This leads to a flow of payments
from households to firms.
Government makes
purchases in both product and resource markets and pays for this. It provides
public goods and services to both businesses and households. Government
collects taxes from businesses and subsidies. It also collects taxes from
households and makes available transfer payments.
Households do not
spend all their income. Some of their income is saved and it is invested to
businesses through financial market. If government has a surplus budget, the
surplus amount also goes to businesses through financial market. If the
opposite happens, government collects the deficit amount from the same.
Intrahousehold and
intrabusiness economic activities are avoided for simplicity.