What does the circular flow model illustrate?

The circular flow model is a fundamental concept in economics that illustrates how money, goods, and services move through an economy. It depicts the interactions between different sectors, typically represented as households and businesses, showing how households provide factors of production—such as labor—to businesses in exchange for wages. In return, businesses produce goods and services that households purchase, which creates a continuous flow of money and resources.

This model emphasizes the interdependence of different economic agents. Households consume the outputs of businesses and provide inputs needed for production, while businesses rely on consumer demand to generate revenue and sustain operations. Thus, the circular flow model comprehensively encapsulates the dynamic nature of economic activity, including how markets facilitate exchanges and how those exchanges lead to economic growth and resource allocation.

Understanding this model is crucial for grasping broader economic concepts, such as income distribution, market equilibrium, and the effects of interventions like taxes or subsidies, although those specific topics fall outside its primary scope. It serves as a foundational tool for visualizing the overall economy's functioning.