Question

The following diagram presents a circular-flow model of a simple economy. The outer set of arrows (shown in green) shows the flow of dollars, and the inner set of arrows (shown in red) shows the corresponding flow of inputs and outputs.

Markets for Goods and Services Firms Households Markets for Factors of Production

Which of the following is true regarding this economic model?

A) While simple, the circular-flow diagram can still be useful for the purposes of modeling how dollars and resources move throughout an economy.

B) Because it does not take into account the role of government, the circular-flow diagram is useless for the purposes of modeling how dollars and resources move throughout an economy.

C) Because it does not take into account international trade, the circular-flow diagram is useless for the purposes of modeling how dollars and resources move throughout an economy.

D) Because, in reality, the economy is very large, the simplicity of the circular-flow diagram makes it useless for the purposes of modeling how dollars and resources move throughout an economy.

Answer 1

A circular flow diagram is quite useful for a simple yet realistic description of the flow of money and goods in the economy. This diagram reveals the basic essence of national income accounting. Although this circular diagram lacks government and international trade, still this diagram is pretty useful to understand the complex mechanics of basic national income identities and complex macro models.

Thus the statement which is true is option (a)  While simple, the circular-flow diagram can still be useful for the purposes of modeling how dollars and resources move throughout an economy.