Eco201 Module 1 - the Big Picture

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1. The Circular Flow diagram is model of how the economy works. Explain how the model would change if the following events occurred: a. The Government reduces spending. b. Households increase savings. A circular flow diagram illustrates the economic exchange that takes place in the building of wealth. It is utilized to show the specific exchanges that are the elements of a particular economy. Simply put, the Circular Flow diagram is a very simplified picture of how money and products are exchanged within an economy. It’s a visual of how our economy works. A circular flow diagram might be used by a business to show how a specific series of exchanges of goods, services and payments make up the building blocks of a given economic system of interest. The diagram above represents all the actors in an economy as either households or firms/companies. In other words, the diagram describes a pure model economy with no government intervention. In addition, the diagram divides markets into two categories: Markets for goods and services, and markets for factors of production or factor markets. Goods and services markets are usually what comes to mind when people think about markets. Firms represent the seller of goods and services while households represent the buyers of goods and services. Products flow from the firms to the consumer or households thru the market. While money flows thru the market from households to firms in exchange for selling their output. Products and money always travel in opposite directions. If the goods and services markets were the only markets in an economy, economic activity would eventually stop because all the money would eventually go into the firms or sellers and all the products will go to the households or buyers. There would be no room for exchange. Fortunately, on the flip side, there are also factor markets or

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