The Money Goes Round: Understanding the Circular Flow of the Macroeconomy

• Money has been called the “lifeblood” of a modern economy. This metaphor is appropriate because just as blood circulates throughout the body helping cells exchange oxygen, energy, and waste chemicals, so, money circulates throughout the economy. Although exchange of goods and services is possible without money (a situation we call barter), money makes the process easier.

• The primary flow of money is in circular fashion from consumers to producers (firms), and back again. In it’s simplest form, this circular flow is represented as money flowing from consumers (Households) to producers (Firms) in exchange for the goods and services the consumers want to consume, such as food, housing, recreation, and all our other goods. But, in order to produce the goods they sell, firms must buy resources such as labor from households. Firms pay for the use of these resources with money the firms received from selling the goods. Once the households get paid for the use of their resources, the circle is complete and households once again have money to spend on goods, starting another trip around the economy.