In the previous section we were introduced to our first economic model: the Circular Flow Model. This simplified model showed how firms and households interacted in the economy. A common theme you may start to notice in learning Economics is that models are usually taught in their simplest manner, and then are expanded to more accurately reflect what is actually happen. In that vein, let's expand the Circular Flow Model to include another economic player: government.
Adding government to the model brings a few more dynamics into the mix. Now, instead of households and firms only interacting with each other, the must also interact with government. Let's look at the new terms that this brings in to more fully understand what the changes that have occurred.
Taxes- Taxes are the payments that firms and households must pay to government. For firms these payments come from revenue, while households pay taxes on their income. This is the method through which government attains purchasing power to engage in transaction in the markets for goods and services (i.e.: product markets) and the markets for factors of production (i.e.:factor markets).
Welfare- Welfare describes the payments of government to households. Examples include social security, food stamps, and Medicare. While this may not always be the case, in the Circular Flow Model these payments are funded by the only source of income the government has: taxes.
Grants- Grants are the payments that governments make to businesses. These payments do not need to be paid back; they are not loans which would require a financial market not included in this model. Examples of grants include money given to company to create environmentally-friendly products and money given to pharmaceutical companies to help in developing new drugs.
Expenditures- These are the payments that governments makes to transact in both the product and factor markets. Once again, government uses the only source of wealth available to them, taxes, to buy goods and services and resources.
Resources- A "resource" in this model, is the name given to factors of production bought buy government. Any land, labor, capital, or entrepreneurship under the possession of government is considered a resource.
That's it for the Circular Flow Model with Government. Two more sectors still need to be included to complete this simplified market: financial markets and global markets. We'll look at those in future articles.