Edited by Mark Blaug and Peter Lloyd
29. Circular flow diagrams Roger E. Backhouse and Yann Giraud The circular flow diagram occurs in virtually all modern introductory economics textbooks as a way of explaining flows of income between firms and households and their measurement in the national accounts. More complicated versions of the diagram then provide the justification for analysing income determination in terms of leakages from and injections into the circular flow of income, which can be analysed using the so-called Keynesian cross. 1. THE DIAGRAM The crucial element in all circular flow diagrams is symbols representing firms and households, which may be drawings of factories and residential houses (usually suburban detached houses) or may involve photographs. One arrow is then drawn running from firms to households, representing the flow of factor payments (wages and profits), with a second arrow on the other side of the diagram going from households to firms, representing spending on goods and services produced by firms. This simplified form of the diagram is represented by the solid lines in Figure 29.1. Sometimes, there will also be arrows going in the opposite direction, denoting the goods and services, including factor services, for which these expenditure flows are payments. The lesson to be drawn from this is that incomes must be exactly equal to expenditure: they measure the same flows of money but at different points in the circuit. It is also possible to measure production of goods and services by firms; because there is nowhere else for this output to be sold,...
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