Households and firms meet in two markets. In the product market, households buy goods and services from firms. In the factor (resource) market, households sell the use of their labor, land and capital to firms. Money flows one way around the loop; goods, services and resources flow the other way.
💡 Why it works
Every purchase has two sides. When you pay a bakery \$5 for bread, that \$5 is your spending and the bakery's revenue. The bakery then pays it out as wages, rent, interest and profit, which are the incomes of households. So one person's spending is another person's income. That is why we can measure the size of an economy either by adding up spending or by adding up income: they are the same dollars counted at two points on the loop.
The simple circular flow. Press "Follow a dollar" to watch one dollar of spending become revenue, then income, then spending again. The toggles add government, financial markets and the rest of the world.
Leakages and injections
Real economies have more sectors. Households also pay taxes, save, and buy imports. Each of these is a leakage: money that leaves the loop of spending on our own output. Firms' investment, government purchases and exports are injections: spending that enters the loop from outside households. When injections are larger than leakages, total spending tends to grow; when leakages are larger, it tends to shrink.
A worked example
✏️ Worked example: Which way does each flow go?
Maria works at a bike shop and earns \$600 a week. On Saturday she spends \$80 at a grocery store. Describe each flow.
Her work is a resource (labor). She sells it in the factor market, so labor flows from a household to a firm.
The \$600 is income. It flows from the firm to the household in the factor market.
The groceries are products. They flow from the store (a firm) to Maria in the product market.
The \$80 is spending. It flows from Maria to the store in the product market, where it becomes the store's revenue.
Answer: Labor and groceries move one way; the \$600 wage and the \$80 payment move the other way.
⚠️ Common mistake
Putting households on the selling side of the product market, or thinking money disappears when it is spent. Households buy products and sell resources; firms do the reverse. And spent money does not vanish: it becomes a firm's revenue and then someone's income. Quick check: for any arrow, ask "who receives this?" Someone always does.
Practice
Pass with 3 right answers, the last 2 in a row. Each right answer earns 1 XP.