What does the circular flow model illustrate?

The circular flow model illustrates the interactions between households and firms within the economy. This model captures how goods and services flow between these two entities, as well as how money circulates in return. Households provide factors of production, such as labor, to firms, and in exchange, they receive wages, which they use to purchase goods and services produced by those firms. This reciprocity creates a continuous flow of economic activity that is fundamental to how economies operate.

The model is integral to understanding fundamental economic concepts like supply and demand, production, and consumption. By illustrating the interdependence between households and firms, it demonstrates how decisions made by one group affect the other, highlighting the dynamic nature of economic interactions.