Circular flow of income

The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow analysis is the basis of national accounts and hence of macroeconomics.The circular flow of income is a concept for better understanding of the economy as a whole and for example the National Income and Product Accounts (NIPAs). In its most basic form it considers a simple economy consisting solely of businesses and individuals, and can be represented in a so-called 'circular flow diagram.' In this simple economy, individuals provide the labour that enables businesses to produce goods and services. These activities are represented by the green lines in the diagram.One of the earliest ideas on the circular flow was explained in the work of 18th century Irish-French economist Richard Cantillon, who was influenced by prior economists, especially William Petty. Cantillon described the concept in his 1730 Essay on the Nature of Trade in General, in chapter 11, entitled 'The Par or Relation between the Value of Land and Labor' to chapter 13, entitled 'The Circulation and Exchange of Goods and Merchandise, as well as their Production, are Carried On in Europe by Entrepreneurs, and at a Risk.' Thornton eds. (2010) further explained:A circular flow of income model is a simplified representation of an economy.Five Sector Circular Flow of Income ModelCircular flow diagram - five sectors modelIn the five sector model, there are leakages and injectionsORS + T + M = I + G + X$100 + $150 + $50 = $50 + $100 + $150$300 = $300$150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + $150 (X)The circular flow of income is significant in four areas:The circular flow diagram is an abstraction of the economy as a whole. The diagram suggests that the economy can reproduce itself. The idea is that as households spend money of goods and services from firms, the firms have the means to purchase labor from the households, which the households to then purchase goods and services. Suggesting that this process can and will continuously go on as a perpetual motion machine. However, according to the Laws of Thermodynamics perpetual motion machines do not exist. The First Laws says matter and energy cannot be created or destroyed, and the Second Laws says that matter and energy move from a low entropy, useful, state towards a less useful higher entropy state. Thus, no system can continue without inputs of new energy that exit as high entropy waste. Just as no animal can live on its own waste, no economy can recycle the waste it produces without the input of new energy to reproduce itself. The economy therefore cannot be the whole. It must be a subsystem of the larger ecosystem.This article incorporates text from Bureau of Economic Analysis. Measuring the Economy : A Primer on GDP and the National Income and Product Accounts, 2014, a publication now in the public domain.