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The circular flow of income is a basic accounting model that helps to demonstrate the inflow of revenue and the relationship of that flow to the general economy. In order to create this model, it is necessary to make a few basic assumptions that are considered likely to apply. While this approach to understanding general money movement can help to provide an overview of the economy, many analysts consider the model to be only one of several tools necessary to fully grasp the state of income flow within a given set of perimeters.
Developing a circular flow of income for a given situation requires making a few basic assumptions. First, it is assumed that the economy is composed of two basic components, sometimes defined as households and firms. In some models, these are referred to as the residential and business sectors. Next, the model will not address the existence of an international component, a government component, or a sector that engages in financial services. In short, it will focus on the reciprocal relationship between income earned from firms and how households are using that income to purchase the goods and services offered by the firms.
While the exercise of calculating a circular flow of income can be helpful in demonstrating the strength or weakness of domestic goods to meet the needs of domestic customers, the model is very limited. This is due to the factors that are not considered as part of the model. For example, the flow of income from the household is assumed to be complete. There are no provisions for households choosing to save part of the income in some form. The model also assumes that all products produced by the firms are actually consumed by domestic households. A typical model for a circular flow of income also does not account for taxes and similar expenses that do absorb a portion of the income flow of any household.