What is the Circular Flow of Economic Activity?

Definition: Circular flow of economic activity is a theory in economics first observed by JM Keynes, which suggests that the money and goods in an economy move in a circle fashion chasing each other indefinitely. In other words, the theory suggests that money and goods from households go to businesses and then back to the households.

What Does Circular Flow of Economic Activity Mean?

What is the definition of circular flow of economic activity? The theory suggests the idea that money should not be hoarded and kept to flow in the economy to ensure economic activity and income. Consumers earn income from their jobs working for producers. They then pay out their income to purchase goods and services from businesses and production facilities.

Their spent money becomes income to the producer that can use this income to fund additional operations. More consumer expenditure leads to more business revenues, which leads to more consumer income available for expenditures. This cycle repeats itself over and over again into infinity.

Let’s look at an example.


Country A has the following economic factors:

  1. Incomes (Y) : $10 Billion
  2. Consumption (C) : $7 Billion
  3. Investment (I) : $3 Billion

Country A (which has an ideal balance of Y = C+I as per the income expenditure theory) is subjected to an interest rate hike by the banks. As a result of increased cost of money, people would end up having less money to spend. This typically leads to lower demand. Lower demand will result in less revenue for business and would culminate in lesser income to the factors.

As such, for an independent economy isolated from the outer world, it becomes imperative for the households to spend and consume. As more consumers spend money on goods and services, the businesses have more money to hire more employees. These higher interest rates stagnate consumer spending.

The same is true when incomes rise. After a certain point, an increase in consumer earnings will not raise consumption. Instead, consumers will save or invest their excess earnings effectively taking them out of the circular economic system.

Summary Definition:

Define the Circular Flow of Economic Activity:Money and goods in an economy move from households to businesses and back to the households.