# Complete circular flow model

Now that we have identified two main participants in the economy, namely households and firms, and two markets, namely the factor and goods markets, we can design a model to show the interactions between firms and households through the goods and factor markets.

### Simple circular flow model with two participants and two markets

After you have worked through this section of the learning unit, you should be able to use the circular flow model to illustrate and explain:

• the interdependence between households and firms
• the real and nominal (monetary) flows through the factor market and the goods market
• the impact of a change in a flow

### Impact of a change in a flow

We can now use this model to explain what happens to the flows if, for instance spending by households increases:

• As spending by households increases, the monetary flow from households to firms increases through the goods market.
• As the goods move from firms to households, the real flow from firms to households increases.
• This increased spending by households causes firms to increase production since the demand for goods is higher. As firms increase production, the production flow increases and more factors of production are employed.
• There is thus an increase in the income flow from firms to households through the factor market.

### Watch the following video clip on the impact on the change in a flow

#### Activity

Do the following activity on the circular flow:

### Choose the correct term in brackets:

As production by firms decreases, the (monetary flow, real flow) of factors of production from households to firms (increases, decreases) through the (goods market, factor market). As a result, the monetary flow to households (increases, decreases) since the income flow is (greater, smaller) from firms to households. This change in the income flow causes the spending flow by households through the (goods market, factor market) to (increase, decrease). This, in turn, causes the (monetary flow, real flow) of goods and services between firms and households to (increase, decrease).

As production by firms decreases, the real flow of factors of production from households to firms decreases through the factor market. As a result, the monetary flow to households decreases since the income flow is smaller from firms to households. This change in the income flow causes the spending flow by households through the goods market to decrease. This, in turn, causes the real flow of goods and services between firms and households to decrease.