The circular flow diagram of economic activity is a model of the:

• A. relationship between government spending and taxation
• B. way in which international trade affects domestic production
• C. process by which monopolies set prices in the market
• D. interactions between households and firms in markets for goods, services, and factors of production

Answer: (D)

Verified step by step guidance

1. Understand that the circular flow diagram is a fundamental model in microeconomics illustrating how money, goods, services, and factors of production move between different sectors of the economy.
2. Identify the main participants in the circular flow model: households and firms. Households provide factors of production (like labor, land, and capital) to firms, and in return, they receive income.
3. Recognize that firms use the factors of production to produce goods and services, which they sell to households in the product markets.
4. Note that households spend their income on goods and services produced by firms, creating a continuous flow of money and resources between these two groups.
5. Conclude that the circular flow diagram specifically models the interactions between households and firms in markets for goods, services, and factors of production, rather than focusing on government spending, international trade, or monopoly pricing.