circular flow of income

Money in an economy does not vanish after it is spent; it keeps going round. When you buy bread, your money becomes the baker's income. The baker spends it on flour and wages, which become a farmer's and a worker's income, who then spend it on other things. The circular flow of income is a simple picture of this endless loop, the most basic map of how a whole economy fits together.

In the simplest version there are two players: households and firms. Households own the resources (labour, land, capital) and sell their use to firms in factor markets, receiving wages, rent and profit. Firms use those resources to make goods and services, which they sell back to households in product markets. So money flows one way round the circle (household spending becomes firm revenue becomes household income) while goods and resources flow the other way. The two flows must match, which is exactly why output equals income equals expenditure. A fuller version adds leakages out of the circle (saving, taxes, spending on imports) and injections back into it (investment, government spending, exports); when injections equal leakages, the flow is balanced.

The circular flow matters because it is the mental scaffolding behind all of macroeconomics. It shows why one person's spending is another's income, why a fall in spending can spread through the whole economy, and why GDP can be measured three ways. It is a deliberately simple model, ignoring things like the financial system's complexity and the rest of the world's detail, but as a first map of the whole economy it is hard to beat.