The circular flow diagram pictures the economy as consisting of two groups — households and firms — that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees. To better understand the economy and the NIPAs, consider a simple economy consisting solely of businesses and individuals, as reflected in the circular flow diagram (1) :
In this simple economy, individuals provide the labor that enables businesses to produce goods and services. These activities are represented by the green lines in the diagram. Alternatively, one can think of these transactions in terms of the monetary flows that occur. Businesses provide individuals with income (in the form of compensation) in exchange for their labor. That income is, in turn, spent on the goods and services businesses produce.
In the real world, there are many different markets for goods and services and markets for many different types of labor.
The total economy is much more complicated than the illustration above. An economy involves interactions between not only individuals and businesses, but also Federal, state, and local governments and residents of the rest of the world. Also, not shown in this simple illustration of the economy are other aspects of economic activity such as investment in capital (produced—or fixed—assets such as structures, equipment, research and development, and software) and flows of financial capital (such as stocks, bonds, and bank deposits). (2)
The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. This is shown in the outer circle, and represents the two sides of the product market (for example, the market for goods and services) in which household’s demand and firms supply.
Households sell their labor as workers to firms in return for wages, salaries and benefits. This is shown in the inner circle and represents the two sides of the labor market in which households supply and firms demand.
This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).
In any circular flow diagram, two flows are present, which can be thought of as two sides of the same coin. The coin can be thought of as GDP, and the two flows are the Expenditure Approach and the Income Approach in measuring GDP. (1)