The circular flow of income or circular flow is a

model A model is an informative representation of an object, person or system. The term originally denoted the plans of a building in late 16th-century English, and derived via French and Italian ultimately from Latin ''modulus'', a measure. Models c ...

of the

economy An economy is an area of the production, distribution and trade, as well as consumption of goods and services. In general, it is defined as a social domain that emphasize the practices, discourses, and material expressions associated with the ...

in which the major exchanges are represented as flows of

money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...

goods In economics, goods are items that satisfy human wants and provide utility, for example, to a consumer making a purchase of a satisfying product. A common distinction is made between goods which are transferable, and services, which are not tran ...

and

services Service may refer to: Activities * Administrative service, a required part of the workload of university faculty * Civil service, the body of employees of a government * Community service, volunteer service for the benefit of a community or a p ...

, etc. between economic agents. The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow analysis is the basis of

national accounts National accounts or national account systems (NAS) are the implementation of complete and consistent accounting techniques for measuring the economic activity of a nation. These include detailed underlying measures that rely on double-entry ...

and hence of

macroeconomics Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and ...

. The idea of the circular flow was already present in the work of

Richard Cantillon Richard Cantillon (; 1680s – ) was an Irish-French economist and author of '' Essai Sur La Nature Du Commerce En Général'' (''Essay on the Nature of Trade in General''), a book considered by William Stanley Jevons to be the "cradle of p ...

.Antoin E. Murphy. "John Law and Richard Cantillon on the circular flow of income." ''Journal of the History of Economic Thought.'' 1.1 (1993): 47-62. François Quesnay developed and visualized this concept in the so-called

Tableau économique The Tableau économique () or ''Economic Table'' is an economic model first described by French economist François Quesnay in 1758, which laid the foundation of the Physiocratic school of economics.Henry William Spiegel (1983) ''The Growth of Ec ...

.Backhouse, Roger E., and Yann Giraud. "Circular flow diagrams." in: ''Famous Figures and Diagrams in Economics'' (2010): 221-230. Chapter 23. Important developments of Quesnay's tableau were

Karl Marx Karl Heinrich Marx (; 5 May 1818 – 14 March 1883) was a German philosopher, economist, historian, sociologist, political theorist, journalist, critic of political economy, and socialist revolutionary. His best-known titles are the 1848 ...

's reproduction schemes in the second volume of '' Capital: Critique of Political Economy'', and

John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...

' ''

General Theory of Employment, Interest and Money ''The General Theory of Employment, Interest and Money'' is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and ...

''.

Richard Stone Sir John Richard Nicholas Stone (30 August 1913 – 6 December 1991) was an eminent British economist, educated at Westminster School and Gonville and Caius College and King's College at the University of Cambridge. In 1984, he was awarded t ...

further developed the concept for the

United Nations The United Nations (UN) is an intergovernmental organization whose stated purposes are to maintain international peace and international security, security, develop friendly relations among nations, achieve international cooperation, and be ...

(UN) and the

Organisation for Economic Co-operation and Development The Organisation for Economic Co-operation and Development (OECD; french: Organisation de coopération et de développement économiques, ''OCDE'') is an intergovernmental organization, intergovernmental organisation with 38 member countries ...

to the system, which is now used internationally.

Overview

The circular flow of income is a concept for better understanding of the

as a whole and for example the

National Income and Product Accounts The national income and product accounts (NIPA) are part of the national accounts of the United States. They are produced by the Bureau of Economic Analysis of the Department of Commerce. They are one of the main sources of data on general econ ...

(NIPAs). In its most basic form it considers a simple economy consisting solely of

business Business is the practice of making one's living or making money by producing or Trade, buying and selling Product (business), products (such as goods and Service (economics), services). It is also "any activity or enterprise entered into for pr ...

es and individuals, and can be represented in a so-called "circular flow diagram." In this simple economy, individuals provide the labour that enables businesses to produce goods and services. These activities are represented by the green lines in the diagram.Measuring the Economy : A Primer on GDP and the National Income and Product Accounts
by Bureau of Economic Analysis (BEA), U.S. Department of Commerce, October 2014. Circular flow of income and expenditure

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 spent on the goods and services businesses produce. These activities are represented by the blue lines in the diagram above. The circular flow diagram illustrates the interdependence of the “flows,” or activities, that occur in the economy, such as the

production Production may refer to: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outline of industrial organization, the act of making products (goods and services) * Production as a stati ...

of goods and services (or the “output” of the economy) and the income generated from that production. The circular flow also illustrates the equality between the income earned from production and the value of goods and services produced. Of course, 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 Capital may refer to: Common uses * Capital city, a municipality of primary status ** List of national capital cities * Capital letter, an upper-case letter Economics and social sciences * Capital (economics), the durable produced goods used f ...

(produced—or fixed—assets such as structures, equipment, research and development, and software), flows of

financial capital Financial capital (also simply known as capital or equity in finance, accounting and economics) is any economic resource measured in terms of money used by entrepreneurs and businesses to buy what they need to make their products or to provide ...

(such as stocks, bonds, and bank deposits), and the contributions of these flows to the accumulation of

fixed asset A fixed asset, also known as long-lived assets or property, plant and equipment (PP&E), is a term used in accounting for assets and property that may not easily be converted into cash. Fixed assets are different from current assets, such as cas ...

History

Cantillon

One of the earliest ideas on the circular flow was explained in the work of 18th century Irish-French economist

, who was influenced by prior economists, especially

William Petty Sir William Petty FRS (26 May 1623 – 16 December 1687) was an English economist, physician, scientist and philosopher. He first became prominent serving Oliver Cromwell and the Commonwealth in Ireland. He developed efficient methods to su ...

. Cantillon described the concept in his 1730 ''

Essay on the Nature of Trade in General ''Essay on the Nature of Trade in General'' (french: Essai sur la Nature du Commerce en Général) is a book about economics by Richard Cantillon. Written around 1730, and published in French in 1755. This book was considered by William Stanley J ...

,'' in chapter 11, entitled "The Par or Relation between the Value of Land and Labor" to chapter 13, entitled "The Circulation and Exchange of Goods and Merchandise, as well as their Production, are Carried On in Europe by Entrepreneurs, and at a Risk." Thornton eds. (2010) further explained: :''Cantillon develops a circular-flow model of the economy that shows the distribution of farm production between property owners, farmers, and workers. Farm production is exchanged for the goods and services produced in the cities by entrepreneurs and artisans. While the property owners are “independent,” the model demonstrates the mutual interdependence between all the classes of people that

Adam Smith Adam Smith (baptized 1723 – 17 July 1790) was a Scottish economist and philosopher who was a pioneer in the thinking of political economy and key figure during the Scottish Enlightenment. Seen by some as "The Father of Economics"——— ...

dubbed the “

invisible hand The invisible hand is a metaphor used by the British moral philosopher Adam Smith that describes the unintended greater social benefits and public good brought about by individuals acting in their own self-interests. Smith originally mention ...

” in

The Theory of Moral Sentiments ''The Theory of Moral Sentiments'' is a 1759 book by Adam Smith. It provided the ethics, ethical, Philosophy, philosophical, Economics, economic, and Methodology, methodological underpinnings to Smith's later works, including ''The Wealth of Nat ...

(1759).'' Cantillon distinguished at least five types of economic agents: property owners, farmers, entrepreneurs, labors and artisans, as expressed in the contemporary diagram of the Cantillon's Circular Flow Economy.

Quesnay

François Quesnay further developed these concepts, and was the first to visualize these interactions over time in the so-called

. Quesnay believed that trade and industry were not sources of wealth, and instead in his 1758 book ''Tableau économique'' (Economic Table) argued that agricultural surpluses, by flowing through the economy in the form of rent, wages, and purchases were the real economic movers, for two reasons. * First, regulation impedes the flow of income throughout all social classes and therefore economic development. * Second, taxes on the productive classes such as farmers should be reduced in favor of higher taxes for unproductive classes such as landowners, since their luxurious way of life distorts the income flow. The model Quesnay created consisted of three economic agents: The "Proprietary" class consisted of only landowners. The "Productive" class consisted of all agricultural laborers. The "Sterile" class is made up of

artisan An artisan (from french: artisan, it, artigiano) is a skilled craft worker who makes or creates material objects partly or entirely by hand. These objects may be functional or strictly decorative, for example furniture, decorative art ...

s and

merchant A merchant is a person who trades in commodities produced by other people, especially one who trades with foreign countries. Historically, a merchant is anyone who is involved in business or trade. Merchants have operated for as long as indust ...

s. The flow of production and/or cash between the three classes started with the Proprietary class because they own the land and they buy from both of the other classes. Quesnay visualised the steps in the process in the Tableau économique.

Marx

In Marxian economics, economic reproduction refers to recurrent (or cyclical) processes by which the initial conditions necessary for economic activity to occur are constantly re-created. Economic reproduction involves the physical ''production'' and ''distribution'' of goods and services, the ''trade'' (the circulation via exchanges and transactions) of goods and services, and the ''consumption'' of goods and services (both productive or

intermediate consumption Intermediate consumption (also called "intermediate expenditure") is an economic concept used in national accounts, such as the United Nations System of National Accounts (UNSNA), the US National Income and Product Accounts (NIPA) and the European ...

and final consumption).

developed the original insights of Quesnay to model the circulation of capital, money, and commodities in the second volume of ''

Das Kapital ''Das Kapital'', also known as ''Capital: A Critique of Political Economy'' or sometimes simply ''Capital'' (german: Das Kapital. Kritik der politischen Ökonomie, link=no, ; 1867–1883), is a foundational theoretical text in Historical mater ...

'' to show how the reproduction process that must occur in any type of society can take place in capitalist society by means of the circulation of capital. Marx distinguishes between "simple reproduction" and "expanded (or enlarged) reproduction". In the former case, no

economic growth Economic growth can be defined as the increase or improvement in the inflation-adjusted market value of the goods and services produced by an economy in a financial year. Statisticians conventionally measure such growth as the percent rate of ...

occurs, while in the latter case, more is produced than is needed to maintain the economy at the given level, making economic growth possible. In the capitalist mode of production, the difference is that in the former case, the new

surplus value In Marxian economics, surplus value is the difference between the amount raised through a sale of a product and the amount it cost to the owner of that product to manufacture it: i.e. the amount raised through sale of the product minus the cost ...

created by wage-labour is spent by the employer on consumption (or hoarded), whereas in the latter case, part of it is reinvested in production.

Further developments

The competitive price system adapted from Samuelson, 1961

An important development was

's 1933 publication of the ''

''. Keynes' assistant

further developed the concept for the

(UN) and the

to the systems, which is now used internationally. The first to visualize the modern circular flow of income model was

Frank Knight Frank Hyneman Knight (November 7, 1885 – April 15, 1972) was an American economist who spent most of his career at the University of Chicago, where he became one of the founders of the Chicago School. Nobel laureates Milton Friedman, George S ...

in 1933 publication of ''The Economic Organization.'' Knight (1933) explained: :'' e may view theeconomic organization as a system of prize relations. Seen in the large, free enterprise is an organization of production and distribution in which individuals or family units get their real income, their "living," by selling productive power for money to "business units" or "enterprises", and buying with the money income thus obtained the direct goods and services which they consume. This view, it will be remembered, ignores for the sake of simplicity the fact that an appreciable fraction of the productive power in use at any time is not really employed in satisfying current wants but to make provision for increased want-satisfaction in the future; it treats society as it would be, or would tend to become, with progress absent, or in a “static” state.'' Knight pictured a circulation of money and circulation of

economic value In economics, economic value is a measure of the benefit provided by a good or service to an economic agent. It is generally measured through units of currency, and the interpretation is therefore "what is the maximum amount of money a specif ...

between people (individuals, families) and business enterprises as a group, explaining: "The general character of an enterprise system, reduced to its very simplest terms, can be illustrated by a diagram showing the exchange of productive power for consumption goods between individuals and business units, mediated by the ''circulation'' of money, and suggesting the familiar figure of the ''wheel of wealth''."

Types of models

A circular flow of income model is a simplified representation of an economy.

Two-sector model

In the basic two-sector circular flow of income model, the economy consists of two

sectors Sector may refer to: Places * Sector, West Virginia, U.S. Geometry * Circular sector, the portion of a disc enclosed by two radii and a circular arc * Hyperbolic sector, a region enclosed by two radii and a hyperbolic arc * Spherical sector, a p ...

: (1) households and (2) firms. (Some sources refer to households as "individuals" or the "public" and to firms as "businesses" or the "productive sector.") The model assumes that there is no

financial sector Financial services are the economic services provided by the finance industry, which encompasses a broad range of businesses that manage money, including credit unions, banks, credit-card companies, insurance companies, accountancy companies, ...

, no government sector, and no foreign sector. In addition, the model assumes that (a) through their expenditures, households spend all of their

income Income is the consumption and saving opportunity gained by an entity within a specified timeframe, which is generally expressed in monetary terms. Income is difficult to define conceptually and the definition may be different across fields. For ...

goods and services Goods are items that are usually (but not always) tangible, such as pens, physical books, salt, apples, and hats. Services are activities provided by other people, who include architects, suppliers, contractors, technologists, teachers, doctor ...

consumption Consumption may refer to: *Resource consumption *Tuberculosis, an infectious disease, historically * Consumption (ecology), receipt of energy by consuming other organisms * Consumption (economics), the purchasing of newly produced goods for curren ...

and (b) through their

expenditure An expense is an item requiring an outflow of money, or any form of fortune in general, to another person or group as payment for an item, service, or other category of costs. For a tenant, rent is an expense. For students or parents, tuition is a ...

s, households purchase all output produced by firms. This means that all household expenditures become income for firms. The firms then spend all of this income on

factors of production In economics, factors of production, resources, or inputs are what is used in the production process to produce output—that is, goods and services. The utilized amounts of the various inputs determine the quantity of output according to the relat ...

such as labor, capital and raw materials, "transferring" all of their income to the factor owners (which are households). The factor owners (households), in turn, spend all of their income on goods, which leads to a circular flow of income.

Three-sector model

The three-sector model adds the government sector to the two-sector model. Thus, the three-sector model includes (1) households, (2) firms, and (3) government. It excludes the financial sector and the foreign sector. The government sector consists of the economic activities of local, state and federal governments. Flows from households and firms to government are in the form of taxes. The income the government receives flows to firms and households in the form of subsidies, transfers, and purchases of goods and services. Every payment has a corresponding receipt; that is, every flow of money has a corresponding flow of goods in the opposite direction. As a result, the

aggregate expenditure In economics, aggregate expenditure (AE) is a measure of national income. Aggregate expenditure is defined as the current value of all the finished goods and services in the economy. The aggregate expenditure is thus the sum total of all the expen ...

of the economy is identical to its

aggregate income Aggregate income is the total of all incomes in an economy without adjustments for inflation, taxation, or types of double counting. Aggregate income is a form of GDP that is equal to Consumption expenditure plus net profits. 'Aggregate income' in ...

, making a circular flow.

Four-sector model

The four-sector model adds the foreign sector to the three-sector model. (The foreign sector is also known as the "external sector," the "overseas sector," or the "rest of the world.") Thus, the four-sector model includes (1) households, (2) firms, (3) government, and (4) the rest of the world. It excludes the financial sector. The foreign sector comprises (a) foreign trade (imports and exports of goods and services) and (b) inflow and outflow of capital (foreign exchange). Again, each flow of money has a corresponding flow of goods (or services) in the opposite direction. Each of the four sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. The addition of the foreign sector

Five-sector model

The five-sector model adds the financial sector to the four-sector model. Thus, the five-sector model includes (1) households, (2) firms, (3) government, (4) the rest of the world, and (5) the financial sector. The financial sector includes banks and non-bank intermediaries that engage in borrowing (savings from households) and lending (investments in firms). Money facilitates such an exchange smoothly. Residuals from each market enter the

capital market A capital market is a financial market in which long-term debt (over a year) or equity-backed securities are bought and sold, in contrast to a money market where short-term debt is bought and sold. Capital markets channel the wealth of savers t ...

as savings, which in turn are invested in firms and the government sector. Technically speaking, so long as lending is equal to borrowing (i.e., leakages are equal to injections), the circular flow will continue indefinitely. However, this job is done by financial institutions in the economy. File:Five Sector Circular Flow of Income Model.jpg, Five Sector Circular Flow of Income Model File:04 circular flow diagram.png, Circular flow diagram - five sectors models

Alternative models

The progression from the two-sector model to the five sector model as documented above (that is, by starting with households and firms, then successively adding the government sector, the foreign sector, and the financial sector) is common. However, some authors group (1) households, (2) firms, and (3) the financial sector together as the "

private sector The private sector is the part of the economy, sometimes referred to as the citizen sector, which is owned by private groups, usually as a means of establishment for profit or non profit, rather than being owned by the government. Employment The ...

" and subsequently add (4) the government sector, making the " domestic sector," and (5) the foreign sector. Others use the "capital market" rather than the "financial sector" to account for the flows of savings and investments; in these sources, the fully specified model has four sectors (households, firms, government, and foreign) plus the capital market, which is regarded as a

market Market is a term used to describe concepts such as: *Market (economics), system in which parties engage in transactions according to supply and demand *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an ...

rather than a sector.

Circular flow of income topics

Leakages and injection

In the five sector model, there are leakages and injections * Leakage means withdrawal from the flow. When households and firms save part of their incomes it constitutes leakage. They may be in form of savings, tax payments, and

imports An import is the receiving country in an export from the sending country. Importation and exportation are the defining financial transactions of international trade. In international trade, the importation and exportation of goods are limited ...

. Leakages reduce the flow of income. * Injection means the introduction of income into the flow. When households and firms borrow savings, they constitute injections. Injections increase the flow of income. Injections can take the forms of investment, government spending and

exports An export in international trade is a good produced in one country that is sold into another country or a service provided in one country for a national or resident of another country. The seller of such goods or the service provider is an ...

. As long as leakages are equal to injections, the circular flow of income continues indefinitely. Financial institutions or capital market play the role of intermediaries. This means that income individuals receive from businesses and the goods and services that are sold to them do not count as injections or leakages, as no new money is being introduced to the flow and no money is being taken out of the flow. Leakages and injections can occur in the financial sector, government sector and overseas sector: ;In the financial sector In terms of the circular flow of income model, the leakage that financial institutions provide in the economy is the option for households to save their money. This is a leakage because the saved money can not be spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector. An example of a group in the finance sector includes banks such as

Westpac Westpac Banking Corporation, known simply as Westpac, is an Australian multinational banking and financial services company headquartered at Westpac Place in Sydney, New South Wales. Established in 1817 as the Bank of New South Wales, ...

or financial institutions such as

Suncorp Suncorp Group Limited is an Australian finance, insurance, and banking corporation based in Brisbane, Queensland, Australia. It is one of Australia's mid-size banks (by combined lending and deposits) and its largest general insurance group, fo ...

. ;In the government sector The leakage that the Government sector provides is through the collection of revenue through taxes (T) that is provided by households and firms to the government. This is a leakage because it is a leakage out of the current income thus reducing the expenditure on current goods and services. The injection provided by the government sector is government spending (G) that provides collective services and welfare payments to the community. An example of a tax collected by the government as a leakage is

income tax An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them (commonly called taxable income). Income tax generally is computed as the product of a tax rate times the taxable income. Tax ...

and an injection into the economy can be when the government redistributes this income in the form of welfare payments, that is a form of government spending back into the economy. ;In the overseas sector The main leakage from this sector are imports (M), which represent spending by residents into the rest of the world. The main injection provided by this sector is the exports of goods and services which generate income for the exporters from overseas residents. An example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter of the wool (the farmer) therefore more money enters the economy thus making it an injection. Another example is China processing the wool into items such as coats and Australia importing the product by paying the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage. ;Summary of leakages and injections :: :''Table 1 All leakages and injections in the five sector model''

The state of equilibrium

In terms of the ''five sector circular flow of income model'' the state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy. This can be shown as:

Savings + Taxes + Imports = Investment + Government Spending + Exports OR S + T + M = I + G + X.

This can be further illustrated through a fictitious economy where:

S + T + M = I + G + X
$100 + $150 + $50 = $50 + $100 + $150
$300 = $300

Therefore, since the leakages are equal to the injections the economy is in a stable state of equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of equilibrium the sum of total leakages does not equal the sum of total injections. By giving values to the leakages and injections the circular flow of income can be used to show the state of disequilibrium. Disequilibrium can be shown as: Therefore, it can be shown as one of the below equations where:

Total leakages > Total injections $150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + $150 (X) Or Total Leakages < Total injections $50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + $150 (X)

The effects of disequilibrium vary according to which of the above equations they belong to. If S + T + M > I + G + X the levels of income, output, expenditure and employment will fall causing a recession or contraction in the overall economic activity. But if S + T + M < I + G + X the levels of income, output, expenditure and employment will rise causing a boom or expansion in economic activity. Circular Flow of Income effects of saving

Circular Flow of Income effects of saving

To manage this problem, if disequilibrium were to occur in the five sector circular flow of income model, changes in expenditure and output will lead to equilibrium being regained. An example of this is if: S + T + M > I + G + X the levels of income, expenditure and output will fall causing a contraction or recession in the overall economic activity. As the income falls households will cut down on all leakages such as saving, they will also pay less in taxation and with a lower income they will spend less on imports. This will lead to a fall in the leakages until they equal the injections and a lower level of equilibrium will be the result. The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the levels of income, expenditure and output will greatly rise causing a boom in economic activity. As the households income increases there will be a higher opportunity to save therefore saving in the

will increase, taxation for the higher threshold will increase and they will be able to spend more on imports. In this case when the leakages increase the situation will be a higher level of equilibrium.

Significance of study of circular flow of income

The circular flow of income is significant in four areas: # Measurement of national income # Knowledge of Interdependence - Circular flow of income signifies the interdependence of each of activity upon one another. If there is no consumption, there will be no demand and expenditure which in fact restricts the amount of production and income. # Unending Nature of Economic Activities - It signifies that production, income and expenditure are of unending nature, therefore, economic activities in an economy can never come to a halt. National income is also bound to rise in future. # Injections and Leakages

Circular flow diagram as a subsystem of the environment

The circular flow diagram is an abstraction of the economy as a whole. The diagram suggests that the economy can reproduce itself. The idea is that as households spend money of goods and services from firms, the firms have the means to purchase labor from the households, which the households to then purchase goods and services. Suggesting that this process can and will continuously go on as a

perpetual motion machine Perpetual motion is the motion of bodies that continues forever in an unperturbed system. A perpetual motion machine is a hypothetical machine that can do work infinitely without an external energy source. This kind of machine is impossible, a ...

. However, according to the Laws of

Thermodynamics Thermodynamics is a branch of physics that deals with heat, work, and temperature, and their relation to energy, entropy, and the physical properties of matter and radiation. The behavior of these quantities is governed by the four laws of the ...

perpetual motion machines do not exist. Daly, Herman E., and Joshua C. Farley. Ecological Economics: Principles and Applications. Washington: Island, 2011. Print. p. 29. The First Laws says matter and energy cannot be created or destroyed, and the Second Laws says that matter and energy move from a low entropy, useful, state towards a less useful higher entropy state. Thus, no system can continue without inputs of new energy that exit as high

entropy Entropy is a scientific concept, as well as a measurable physical property, that is most commonly associated with a state of disorder, randomness, or uncertainty. The term and the concept are used in diverse fields, from classical thermodynam ...

waste. Just as no animal can live on its own waste, no economy can recycle the waste it produces without the input of new energy to reproduce itself. The economy therefore cannot be the whole. It must be a subsystem of the larger

ecosystem An ecosystem (or ecological system) consists of all the organisms and the physical environment with which they interact. These biotic and abiotic components are linked together through nutrient cycles and energy flows. Energy enters the syste ...

. The

abstraction Abstraction in its main sense is a conceptual process wherein general rules and concepts are derived from the usage and classification of specific examples, literal ("real" or "concrete") signifiers, first principles, or other methods. "An abstr ...

ignores the linear throughput of matter and energy that must power the continuous motion of money, goods and services, and factors of production. Matter and energy enter the economy in the form of low entropy

natural capital Natural capital is the world's stock of natural resources, which includes geology, soils, air, water and all living organisms. Some natural capital assets provide people with free goods and services, often called ecosystem services. All of t ...

, such as

solar energy Solar energy is radiant light and heat from the Sun that is harnessed using a range of technologies such as solar power to generate electricity, solar thermal energy (including solar water heating), and solar architecture. It is an essenti ...

oil well An oil well is a drillhole boring in Earth that is designed to bring petroleum oil hydrocarbons to the surface. Usually some natural gas is released as associated petroleum gas along with the oil. A well that is designed to produce only gas may ...

fisheries Fishery can mean either the enterprise of raising or harvesting fish and other aquatic life; or more commonly, the site where such enterprise takes place ( a.k.a. fishing ground). Commercial fisheries include wild fisheries and fish farms, both ...

, and mines. These materials and energy are used by households and firms a like to create products and wealth. After the material are used up, the energy and matter leaves the economy in the form of high entropy waste that is no longer valuable to the economy. The natural materials that power the motion of the circular flow of the economy come from the environment, and the waste must be absorbed by the larger ecosystem in which the economy exists. Daly, Herman E., and Joshua C. Farley. Ecological Economics: Principles and Applications. Washington: Island, 2011. Print. p. 29-34. This is not to say that the circular flow diagram isn't useful in understanding the basics of an economy, such as leakages and injections. However, it cannot be ignored that the economy intrinsically requires

natural resource Natural resources are resources that are drawn from nature and used with few modifications. This includes the sources of valued characteristics such as commercial and industrial use, aesthetic value, scientific interest and cultural value. O ...

s and the creation of waste that must be absorbed in some manner. The economy can only continue churning if it has matter and energy to power it and the ability to absorb the waste it creates. This matter and low entropy energy and the ability to absorb waste exists in a finite amount, and thus there is a finite amount of inputs to the flow and outputs of the flow that the environment can handle, implying there is a sustainable limit to

motion In physics, motion is the phenomenon in which an object changes its position with respect to time. Motion is mathematically described in terms of displacement, distance, velocity, acceleration, speed and frame of reference to an observer and mea ...

, and therefore growth, of the economy.

References

;Attribution This article incorporates text from

Bureau of Economic Analysis The Bureau of Economic Analysis (BEA) of the United States Department of Commerce is a U.S. government agency that provides official economy of the United States, macroeconomic and industry statistics, most notably reports about the gross domestic ...

.
Measuring the Economy : A Primer on GDP and the National Income and Product Accounts
'' 2014, a publication now in the public domain.

External links

Circular Flow
, The Economic Lowdown Video Series at stlouisfed.org/ {{Authority control Economics models