Circular Flow of Income

Two cycles are moving in opposite directions in an economy. One is the flow of money from firms to individuals and back to firms again: people earn money from working which they use to purchase goods and services. The other is the flow of goods and services from individuals to firms and back again: people go to work to produce things for daily consumption. 

Circular Flow of Income Circular Flow of Income

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Table of contents

    Discover the fascinating circular flow of income concept and its impact on economic stability. Learn how to decipher the circular flow of income diagram, explore the different types of flow in the circular flow of income, and examine the two-sector circular flow of income model. We will also uncover the complexities of the expanded circular flow of income models and the roles of injections and leakages. Finally, see an example of the circular flow of income. This comprehensive guide will provide you with a clear understanding of the interconnected nature of our economy. Ready to unravel the economic forces that drive our world? Let's get started!

    What is the Circular Flow of Income?

    The circular flow of income model is a simple way to visualize how money constantly circulates between households and businesses within an economy. Households earn money through wages and salaries, then spend that money on goods and services provided by businesses, ensuring a continuous flow of funds that keeps the economy thriving.

    The circular flow of income model is a graphical representation of the cyclical movement of money between households and businesses in an economy, depicting the exchange of labor and resources for income and the subsequent spending of that income on goods and services produced by businesses.

    Imagine a small town with a bakery and its residents. The bakery employs townspeople, paying them wages for their work. The residents then use their earnings to buy delicious bread and pastries from the bakery. This ongoing exchange of money for goods and services keeps both the bakery and the residents prosperous, illustrating the concept of the circular flow of income.

    In the basic model, the circular flow of income consists of two components:

    • Firms: companies that produce goods and pay wages to employees.
    • Households: individuals who receive wages from firms while simultaneously purchasing the goods and services from the firms.

    In the real world, the model is a bit more complicated. It has two extra components:

    • Government: the government receives taxes from firms and households, then uses tax revenues to pay for public services.
    • Foreign sector: the foreign sector is responsible for exporting and importing goods, thus facilitating an exchange of money between the domestic economy and the rest of the world.

    In addition to firms, households and governments, there is also the financial sector that enables money exchange and helps to convert savings into investments for economic development.

    In the economy, goods and services move in one direction while money flows in the other way. Goods, money, and services are the three major flows in the economy.

    The circular flow of income also represents three ways to calculate the national income:

    • The national output shows the actual value of goods and services produced by the economy.
    • The national income represents the total earnings received by people in the economy. These include profits, dividends, wages, and rent. For example, workers receive wages from firms.
    • The national expenditure shows the total amount spent on goods and services. For example, individuals use money from their wages to purchase goods and services from firms.

    Circular Flow of Income Diagram

    The Circular flow of income diagram is a simple yet powerful visual representation of how money and resources move within an economy. It illustrates the continuous exchange of goods, services, and income between households and firms, highlighting the interdependence of these key economic agents. Look at figure 1 to see the fundamental processes that drive an economy.

    Income (Y) = Output (O) = Expenditure (E)

    The Circular Flow of Income Model StudySmarterFig. 1 - Circular flow of income

    Types of Flow in Circular Flow of Income

    The circular flow consists of two main aspects: real flow and money flow. Both concepts demonstrate how money is exchanged for goods and services. However, while the real flow refers to the actual flow of goods and services, the money flow involves the payments for services and consumption.

    The real flow

    The real flow involves two kinds of flows: the flow of factors of production such as land and labour from individuals to firms, and the flow of goods and services from firms to individuals. The real flow depicts how the economy produces and consumes products and services.

    The money flow

    The money flow transfers money and other forms of credit in the economy. It happens when companies pay wages to workers in exchange for their labour and when individuals use their wages to pay for goods and services. In the money flow, income is turned into savings and investments, then back again.

    To learn how money is used for investment, check out our explanation on Money Markets.

    Two-sector Circular Flow of Income Model

    The two-sector circular flow of income model is a simple picture of an economy in which the economy is divided into two components: individuals and firms. Individuals are also called households or the public, while firms are businesses or the productive sector. The financial sector, government sector, and overseas sector are excluded in this model.

    The model is based on two assumptions:

    1. Individuals spend all their income on goods and services without the intention of saving part of their income.
    2. Consumers purchase all output created by companies through their consumption.

    Thus, all expenses by individuals are converted into income for businesses. Companies then spend all their earnings on labour, capital, and raw materials, transferring them back to individuals. This results in a circular income flow.

    Circular flow of income two-sector model StudySmarterFig. 2 - Two-sector circular flow of income model

    Expanded Circular Flow of Income Models

    The circular flow model can be expanded in several ways depending on the economic sectors involved. Here are the most common combinations of economic factors in the circular flow.

    Three-sector model

    The government is added to the basic circular flow model (two-sector model) in the three-sector circular flow model. The financial and overseas sectors are not included.

    The government sector is made up of economic activities by the municipal, state, and federal governments.

    Taxes (T) are the means through which the government generates income from individuals and businesses. Government spending (G), including subsidies, transfers, and purchases of products and services, is how the government redistributes its revenue to businesses and individuals.

    Every payment has an equal and opposite reception. That is, each flow of money has an equal and opposite flow of commodities. As a result, the economy’s aggregate expenditure equals its aggregate income, which creates a circular flow.

    In this model, the national income is in equilibrium when taxes equal government spending: T=G

    Circular flow of income three-sector model StudySmarterFig. 3 - Three-sector circular flow of income

    Four-sector model

    In the four-sector circular flow, the overseas sector is added to the three-sector circular flow model. The external sector and foreign sector are all terms used to describe the overseas sector. The four-sector circular flow model consists of individuals, businesses, the government, and overseas. The financial sector is not included.

    The overseas sector is made up of imported (M) and exported (X) commodities and services, also known as foreign commerce. Each transfer of money, once again, is accompanied by a flow of products/services in the other direction.

    In this model, the national income is in equilibrium when: T+M=G+X

    Circular flow of income four-sector model StudySmarterFig. 4 - Four-sector circular flow of income model

    Five-sector model

    In the five-sector model, the financial sector is added to the four-sector circular flow model. This model includes all five economic agents: individuals, businesses, the government, overseas, and the financial sector.

    The financial sector comprises banks and non-bank entities that help invest individuals' funds in businesses.

    The individuals’ excess money enters the capital market as savings, which are then invested in businesses and the government sector. Indefinitely, the cyclic flow will continue, and the national income reaches equilibrium when intended saving or spending withdrawal matches planned investment (I) or spending (S) injection into the flow. S = I

    If savings exceed investments, there will be less production and income. On the other hand, if investments exceed savings, this will result in more production and income.

    Savings can either be hoarded or loaned out to others. Hoarding entails not spending a portion of one's income, such as holding money in one's closet. This can lead to a lack of aggregate demand in the economy. As a result, firms won't be able to sell all the goods and services they produce, resulting in lower incomes and national revenue. On the other hand, financial institutions in the economy facilitate the lending or borrowing of money.

    In the 5-sector model, the national income is in equilibrium when: S + T + M = I + G + X

    Circular flow of income five-sector model StudySmarterFig. 5 - Five-sector circular flow of income model

    Injections in the Circular Flow of Income

    Injections in the circular flow of income refer to external factors that increase the flow of money within an economy. These injections are essential for stimulating economic growth and can come in the form of government spending, investments, and exports. For example, when the government invests in infrastructure projects, it creates new jobs and increases household income, thus injecting money into the economy. Similarly, when a local business exports its products to foreign markets, it brings in additional income, which also serves as an injection into the circular flow.

    Injections in the circular flow of income are the external economic activities that introduce money into the economy, thereby increasing the total income circulating within the system. Injections are classified into three main categories: government spending (G), investments (I), and exports (X).

    Circular Flow of Income Leakages

    Leakages, on the other hand, are factors that remove money from the circular flow of income, leading to a slowdown in economic activity. Common leakages include savings, taxes, and imports. For instance, when households decide to save a portion of their income instead of spending it on goods and services, this money is removed from circulation, causing a leakage. Another example is when people pay taxes to the government; this portion of their income is no longer available for spending, reducing the circular flow. Finally, importing goods and services from other countries results in money leaving the domestic economy, which is also considered a leakage in the circular flow of income.

    Leakages in the circular flow of income are the economic activities that remove money from the circulation within an economy, causing a reduction in the overall flow of income. The primary types of leakages include savings (S), taxes (T), and imports (M).

    Circular Flow of Income Equilibrium and Disequilibrium

    If the total leakages in the economy equal the total injections, then the circular flow of income will be in equilibrium.

    Let's take a look at an example:

    Total leakages = Savings(S) + Taxes(T) + Imports(M)

    = £50 + £100 + £200

    = £350

    Total Injections = Investment(I) + Government Spending(G) + Exports(X)

    = £200 + £50 + £100

    = £350

    Total leakages = Total Injections

    £350 = £350

    If the total number of leakages does not equal the total number of injections, it leads to disequilibrium. This is shown in the equation:

    Savings(S) + Taxes(T) + Imports(M) ≠ Investment(I) + Government Spending(G) + Exports(X)

    When the government increases its spending, consumer spending, production, and employment will also rise, resulting in economic growth or expansion:

    Savings(S) + Taxes(T) + Imports(M) < Investment(I) + Government Spending(G) + Exports(X)

    £50 + £170 + £200 < £200 + £50 + £300

    £420 < £550

    When people hoard money in their savings accounts, production, spending, and employment will decrease, resulting in a reduction of economic activities:

    Savings(S) + Taxes(T) + Imports(M) > Investment(I) + Government Spending(G) + Exports(X)

    £200 + £50 + £300 > £50 + £170 + £200

    £550 > £420

    If disequilibrium occurs in the circular flow of income, adjustments in government expenditure and savings will restore equilibrium.

    Circular Flow of Income Example

    Two better understand the circular flow of income model, we prepared a comprehensive example of a simplified economy showing the evolution of the circular flow of income from a simple two-sector model to a more complex five-sector model, accounting for the various economic agents and their interactions. Understanding these relationships is crucial for comprehending an economy's overall health and growth.

    Two-Sector Model: Households and Businesses

    Let's start by considering a simple two-sector model of the circular flow of income. Imagine a small town with a popular bubble tea shop, a grocery store, and several households. The bubble tea shop sells drinks to the grocery store, which in turn sells them to households. The households pay for the bubble tea, and the grocery store uses that money to pay the bubble tea shop. At the same time, both the bubble tea shop and grocery store employ people from the households, paying them wages for their labor. The households then use their income to purchase goods and services from businesses, such as the bubble tea shop and the grocery store.

    Three-Sector Model: Adding the Government

    As we expand our model to include the government, we introduce taxes, government spending, and transfer payments. In this scenario, the government collects taxes from both households and businesses, which can be seen as a leakage from the circular flow of income. However, the government also spends money on public goods and services, such as building a new park, and provides transfer payments, like unemployment benefits, injecting money back into the economy.

    Four-Sector Model: Incorporating Foreign Trade

    Next, we add foreign trade into the mix, accounting for exports and imports. The bubble tea shop may decide to export its products to other countries, bringing in foreign income and boosting the local economy. Conversely, the grocery store may import some products from other countries, such as exotic fruits. The money spent on these imports will leave the local economy and become a leakage.

    Five-Sector Model: Introducing Financial Institutions

    Finally, we incorporate financial institutions like banks into our model. These institutions play a crucial role in the circular flow of income by facilitating savings, investments, and loans. For example, households may save a portion of their income in a bank, reducing their spending on goods and services. The bank then lends this money to businesses, like the bubble tea shop, which can use it to expand its operations or invest in new equipment. This investment becomes an injection into the circular flow of income.

    Circular Flow of Income - Key takeaways

    • The circular flow of income model is a graphical representation of the exchange of money, labor, and resources between households and businesses in an economy.
    • The basic model has two main components: firms (businesses) and households (individuals).
    • The model can be expanded to include the government, foreign trade, and financial institutions, creating a more comprehensive picture of an economy's overall health and growth.
    • Injections (such as government spending, investments, and exports) and leakages (such as savings, taxes, and imports) can impact the flow of money within an economy, affecting its overall growth and stability.
    • Equilibrium in the circular flow of income occurs when total leakages equal total injections; disequilibrium can lead to economic expansion or contraction.
    • The model highlights the interdependence between households, businesses, and other economic agents, demonstrating the importance of understanding their relationships.
    • The circular flow of income model can be used to calculate national income through national output, national income, and national expenditure.
    • Understanding the circular flow of income is crucial for comprehending an economy's overall health and growth, informing economic policy and decision-making.
    Frequently Asked Questions about Circular Flow of Income

    How does saving affect the circular flow of income?

    Saving affects the circular flow of income by causing a leakage, as money saved by households is not spent on goods and services, reducing the overall flow.

    Does government spending increase the circular flow of income?

    Government spending increases the circular flow of income by stimulating economic activity and injecting money into the economy.

    How do you explain the circular flow of an economy?

    The circular flow of income, also known as circular flow, is an economic model in which necessary trades are represented as money, products, and services flows between economic players.

    What are the three major flows in the economy?

    The three major flows in the economy are goods, money, and services.

    What are the types of circular flow?

    The types of circular flow are real and money flow.

    What are the key features of circular flow?

    The key features of circular flow are the individuals, the businesses, the overseas, the government and the financial sector.

    What is the four sector model of the circular flow of income?

    The four-sector model of the circular flow of income is the model where the overseas sector is added to the three-sector circular flow model.

     What is an injection in the circular flow of income? 

    Injections in the circular flow of income refer to external factors that increase the flow of money within an economy, such as government spending, investments, and exports.

    Do exports add to the circular flow of income?

    Yes, exports add to the circular flow of income by bringing in additional income from foreign markets.

    How does unemployment affect the circular flow of income?

    Unemployment affects the circular flow of income by decreasing household income, reducing spending on goods and services, and slowing down economic activity.

    Test your knowledge with multiple choice flashcards

    The businesses and the individuals are the two groups that interact in the diagram.

    In the circular flow graphic, individuals both receive and spend money.

    Taxes are the means through which money flows from individuals and businesses to the government. 

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