What does the circular flow of income model illustrate?

The circular flow of income model illustrates the interactions between households and firms in an economy by demonstrating how money and goods circulate. In this model, households provide factors of production—such as labor—to firms, and in return, they receive wages, rent, interest, and profits. This creates a continuous flow of income.

Simultaneously, firms produce goods and services that households purchase, creating consumption expenditure. The model highlights the interdependence between consumers and producers, showing how economic activity and income generation are interconnected. It simplifies complex economic relationships into a clear framework that helps in understanding basic economic principles such as production, income, and expenditure. Understanding this model is crucial because it lays the groundwork for further economic analysis, including how different sectors interact and how government policies may influence these flows.