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The Circular Flow Model Review for AP Economics

By — McGraw-Hill Professional
Updated on Mar 2, 2011

Review questions for this study guide can be found at:

Macroeconomic Measures of Performance Review Questions for AP Economics

Main Topic: Circular Flow Model of a Closed Economy

The Circular Flow Model

"What comes around goes around." If you remember nothing else about the circular flow model, remember this old phrase. The circular flow of goods and services (or circular flow of economic activity) is a model of an economy showing the interactions among households, firms, and government as they exchange goods and services and resources in markets. In other words, it is a game of "follow the dollars."

Figure 12.1 illustrates a model of a closed economy, where the foreign markets are not assumed (yet) to exist. Domestic households offer their resources to firms in the resource market so that those firms can produce goods and services. The households are paid competitive prices for those resources. They use that income to consume the very goods that were produced through the employment of their productive resources. Revenues from the sale of goods and services are then used to provide income to those households. In this simplified model, every dollar of income in the household ends up as revenue for the firm.

"What About the Government?"

Though not pictured in Figure 12.1 the government plays an important role in the circular flow model. The government is an employer of inputs and a producer of goods and services. The government collects taxes both from households and firms and uses the funds to pay for the inputs that they employ.

"How Much Economic Activity is Being Generated?"

We can add up all of the dollars earned as income by resource owners; or we can add up all of the spending done on goods and services; or we can add up the value of all of those goods and services.

"Where Does it Begin, Where Does it End?"

It doesn't matter; it's the counting of the dollars that is the important first step in measuring economic performance.

The Circular Flow Model

Macroeconomic Goals

Figure 12.1 implies that a steady flow of goods and dollars circulating throughout the economy is necessary or commerce ceases. The big issue is how we keep this flow strong, and how we know when it is weak. Measuring success is the focus of the sections that follow. Most modern societies maintain the fairly broad goal of keeping spending and production in the macroeconomy strong without drastically increasing prices.

Review questions for this study guide can be found at:

Macroeconomic Measures of Performance Review Questions for AP Economics

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