Question

Which statement is true about the circular flow diagram of an economy?

1) It represents the flow of goods and services between households and firms.
2) It shows the flow of money between households and firms.
3) It illustrates the interaction between the government and the private sector.
4) It demonstrates the circular flow of income and expenditure in an economy.

Answer 1

The circular flow diagram represents the exchange of goods and services for money between households and firms, illustrating the flow of goods, services, and money that creates a continuous loop of economic activity.

Step-by-step explanation:

The circular flow diagram of an economy accurately represents a few facets of economic interaction. First, it illustrates the flow of goods and services between two primary economic agents: households are seen buying goods and services from firms, while firms are depicted providing these to households.

Simultaneously, the diagram displays the flow of labor and capital in the reverse direction, with households providing labor to firms and receiving compensation in return. This is known as the labor market. Thus, both money and goods/services circulate through the economy in a continuous loop, reflecting the circular flow of income and expenditure.