Circular Flow Diagram Flashcards, test questions and answers

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What is Circular Flow Diagram?

A Circular Flow Diagram (CFD) is a graphical representation of an economic system that shows how money, goods, and services flow through the economy. It helps to illustrate how different economic actors interact and their respective roles in the economy. The diagram has two loops, one representing the flow of income and another representing the flow of production. The inner loop represents the flow of money, goods and services from households to firms for the purpose of purchasing goods or services. This is called consumer spending. Firms then use this revenue to buy resources such as labour, capital and raw materials in order to produce more goods or services which they can then sell back to households at a profit. This is known as business investment or production expenditure. The outer loop represents the circular flow between firms and government entities such as taxes, transfers and subsidies which ultimately return back to households through government spending on public goods like education or health care. This is known as government expenditure/fiscal policy; it affects all parts of society by providing funds for essential public projects like infrastructure development or job creation programs that help keep an economy running smoothly. Ultimately, CFDs help us understand how different economic agents interact with each other in an economy from households spending money on things they need or want; businesses investing revenues into creating new products; governments regulating these activities with taxes, subsidies and other policies ultimately resulting in a steady-state equilibrium where everybody benefits from a healthy economy that produces enough wealth for everyone involved in it.