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Circular Flow

Jones, L. R. (1993). “Counterpoint Essay: Nine Reasons Why If, for example, a business wants to build a small
the CFO Act May Not Achieve Its Objective.” Public Budget- plant to produce electronic equipment, it must have land
ing & Finance, 13(1):,87-94.
on which to build the plant. In the process of building the
Jones, L. R., and McCaffery, Jerry L. (1997). “Implementing the plant, it uses human laborers who in turn use natural
Chief Financial Officers Act and the Government Perfor- resources to construct the building. Capital to complete
mance and Results Act in the Federal Government.” Public
Budgeting & Finance, 17(1): 35-55. the building comes ultimately from households, usually
by means of some type of financial institution that lends
Jones, L. R., and McCaffery, Jerry L. (1992). “Federal Financial
Management Reform and the Chief Financial Officers Act.” money to the entrepreneurs (who also come from house-
Public Budgeting & Finance, 12(4): 75-86. holds) to construct the electronics plant.
Jones, L. R., and McCaffery, Jerry L. (1993). “Implementation Product markets are where goods and services are
of the Federal Chief Financial Officers Act.” Public Budgeting sold. In the case of the plant that produces electronic
& Finance, 13(1): 68-76. equipment, the outlets for its products might be retail
Steinberg, Harold I., and Von Brachel, John (1996). “The CFO stores. Members of households purchase the equipment
Act: A Look at Federal Accountability.” Journal of Accoun- for their own use in the household. Pieces of electronic
tancy, 181(3): 55-57.
equipment are purchased by the households that also pro-
vided the resources that made it possible to build the
Jean E. Harris product. The outside circle of the process shown in Figure
1 has been completed.
In the reverse direction is the flow of spending.
Beginning with households, the individuals therein spend
CIRCULAR FLOW money for the purchase of goods and services that are pro-
Circular flow describes how a market economy works. A vided by businesses. In our example, the purchase is of a
market economy is one in which individuals influence finished piece of electronic equipment. The money that is
directly what is produced, marketed, and consumed. Indi- spent on the equipment flows from households to the
viduals do this by spending money on what they want. business, making it possible for the business to sustain
This then directs producers to produce goods and services operations.
that individuals will consume. The amount of goods and To sustain operations, the business must pay workers
services that are made available is related to the laws of and purchase resources. Money continues to flow through
supply and demand.
the business into the resource markets. Bear in mind that
A model that best depicts how goods and services one of the vital resources for the operation of a business is
flow in exchange for money is called the circular flow human resources, which are supplied by households.
model, shown in Figure 1. Some of the money that passes through the business goes
back into the households as pay for the use of the human
PARTICIPATION resources. Once again, the circular flow is complete:
The primary participants in the circular flow of goods and money that came from households through the purchase
services are businesses and households. Households are of electronic equipment passes back to households in the
made up of individuals who both spend money and are form of wages.
the recipients of money. Businesses do the same—they The money flow is more extensive than just wages, as
spend money and also receive money from households. It shown in Figure 1. Households do not spend all their
is important to note that the flow of goods and services is wages on goods and services. Some of the money goes into
in one direction in Figure 1, while the flow of money banks, financial investments, real estate, and numerous
expenditures is in the opposite direction. Both flows make other places. From those resources, households expect to
a complete circle—hence, it is called the circular flow of receive interest or rent as the resource is used. Banks and
goods and service. other financial institutions do not simply hold the money
that is deposited by the households—instead, they use it
MARKETS to provide capital for building electronic plants and for
There are two types of markets in the circular flow of numerous other reasons. The money flows back and forth
goods and services. The resource market is where busi- through the circle.
nesses purchase what they use to produce goods and ser- The two flows of income and expenditures are equal.
vices. Resources are in the form of labor, natural resources, Expenditures on products are ultimately someone’s house-
capital, and entrepreneurship, all of which are supplied by hold income. Income that flows into households is
households. expended in some way, either for goods and services or to

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