Circular Flow of Income

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.

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)

Fig. 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.

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.

Fig. 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

Fig. 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

Fig. 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

Fig. 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.

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.

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:

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.