Circular Flow: A Simple Model of the Economy

7 Pages Posted: 5 Apr 2010

See all articles by Peter Marcel Debaere

Peter Marcel Debaere

University of Virginia - Darden School of Business; Centre for Economic Policy Research (CEPR)


This note discusses circular flow. With a simple model, it is shown how changes in the components of expenditures affect overall income. The analysis is both graphical and algebraic.



Rev. Aug. 19, 2009

Circular Flow: A Simple Model of the Economy

As firms make strategic decisions, it is important that they understand the environment in which they operate. Therefore, it is essential that managers, like policymakers, understand what determines the performance of an economy and that managers are able to anticipate the impact of policy decisions. What makes gross domestic product (GDP) increase? What accounts for unemployment? What is the role of prices in all of this? To better understand the economy, economists build models that separate out the various driving forces in the economy. In this note, we sketch a simple model of a closed economy that we will enrich during the course. The model specifies a number of key factors and key aggregates and how they relate to one another. We present both a graphical and an algebraic analysis. The model we present here is an essential building block of the IS/LM model that we will be using later and that is still the workhorse of policy analysis at the U.S. Federal Reserve, international organizations such as the International Monetary Fund (IMF), and various other financial institutions.

The Circular Flow

The starting point is the circular flow chart of an economy. There are two ways to consider the output of a country, or its GDP. On one hand, GDP is the income of a country. On the other hand, however, GDP is the sum of all expenditures in the economy. Because income and expenditures are so closely linked, it is important to specify exactly how they are intertwined, so we can predict how changes in the economy may affect the overall output, prices, and unemployment.

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Keywords: circlular flow

Suggested Citation

Debaere, Peter Marcel, Circular Flow: A Simple Model of the Economy. Darden Case No. UVA-G-0596, Available at SSRN:

Peter Marcel Debaere (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States


Centre for Economic Policy Research (CEPR)

United Kingdom

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