Circular Flow diagram also called the circular flow model is perhaps the simplest diagram in economics to understand the activity in the economy.
The circular flow model shows,firstly the relationship between households and firms,and secondly how they interact with one another in two markets,namely,in goods and services market and the factor of production market.
In the goods and services market,is where all products made by firms are exchanged. The factor of production market is where inputs such as land,labour,capital and other resources are exchanged.
In the factor market,households sell and firms buy resources. In the goods and services market,the firms sell and households buy products.
Households use the income they obtain from selling resources to purchase the goods and services produced by the firms,and in the economy there is a true flow of resources and products and a flow of income and expenditure.
Thus,every transaction has two parties,a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. Finally both income and expenditure is equal. This is true to all economic activity. This equality of income and expenditure is described with the circular flow model.