The circular-flow diagram (or circular-flow model) is a graphical representation of the flows of goods and money between two distinct parts of the economy:
-market for goods and services, where households purchase goods and services from firms in exchange for money;
-market for factors of production (such as labour or capital), where firms purchase factors of production from households in exchange for money.
The market for goods and services is the place where households spend their money buying goods and services produced by firms. In other words, is the place where firms sell the goods and services they have produced, receiving a revenue paid by households.
This market represents the place where money and goods are exchanged. In this case, the flow of money (green arrow in the diagram below) goes from households to firms, in exchange for finished products, which flow from firms to households (red arrow).
The market for factors of production is the place where households offer their labour, capital and other factors such as land, receiving an income for their use. Firms use these factors in their production.
In this case, money flows from firms to households (green arrow in the diagram below) in the form of wages in exchange for labour, interests for capital and rent for the use of land. Factors of production flow form households (red arrow) to firms, so they can produce more goods and services.
When we combine both diagrams, we get the circular-flow diagram, as shown below. The exchanges made in the economy imply a redistribution of rent according to the diagram, and the creation of value makes the economy grow.
It’s worth mentioning that, as usually, diagrams do not shown how the economy actually works. There are a few things that are not showed in this diagram that must be taken into account to really understand how the economy of a country works. For instance, take government intervention. Things such as government spending (in the form of unemployment benefits, for example) or government income (taxes) are not shown in the diagram.
However, this diagram introduces a clear view of how the economy works. The way of measuring all these flows of money is the gross domestic product (GDP). It can be estimated using one of three methods: looking at total expenditure, at total income or using the production approach.