From Wikipedia, the free encyclopedia Circular flow of income

Circular flow of income

More complete and realistic circular flow
models are more complex. They would expli-
citly include the roles of government and fin-
ancial markets, along with imports and
exports.
Labor and other "factors of production"
are sold on resource markets. These re-
sources, purchased by firms, are then used to
produce goods and services. The latter are
sold on product markets, ending up in the
hands of the households, helping them to
supply resources.

In this simplified image, the relationship

between the decision-makers in the circular Assumptions
flow model is shown. Larger arrows show The basic circular flow of income model con-
primary factors, whilst the red smaller ar-
sists of six assumptions:
rows show subsequent or secondary factors.
1. The economy consists of two sectors:
households and firms.
In economics, the term circular flow of in-
2. Households spend all of their income (Y)
come or circular flow refers to a simple
on goods and services or consumption (C).
economic model which describes the recip-
There is no saving (S).
rocal circulation of income between produ-
3. All output (O) produced by firms is
cers and consumers.[1][2] In the circular flow
purchased by households through their
model, the inter-dependent entities of produ-
expenditure (E).
cer and consumer are referred to as "firms"
4. There is no financial sector.
and "households" respectively and provide
5. There is no government sector.
each other with factors in order to facilitate
6. There is no overseas sector.
the flow of income[1]. Firms provide con-
sumers with goods and services in exchange
for consumer expenditure and "factors of pro- Two Sector Model
duction" from households.
In the simple two sector circular flow of
The circle of money flowing through the
income model the state of equilibrium is
economy is as follows: total income is spent
defined as a situation in which there is no
(with the exception of "leakages" such as
tendency for the levels of income (Y), ex-
consumer saving), while that expenditure al-
penditure (E) and output (O) to change, that
lows the sale of goods and services, which in
is:
turn allows the payment of income (such as
Y=E=O
wages and salaries). Expenditure based on
This means that the expenditure of buyers
borrowings and existing wealth – i.e., "injec-
(households) becomes income for sellers
tions" such as fixed investment – can add to
(firms). The firms then spend this income on
total spending.
factors of production such as labour, capital
In equilibrium (Preston), leakages equal
and raw materials, "transferring" their in-
injections and the circular flow stays the
come to the factor owners. The factor owners
same size. If injections exceed leakages, the
spend this income on goods which leads to a
circular flow grows (i.e., there is economic
circular flow of income.
prosperity), while if they are less than leak-
ages, the circular flow shrinks (i.e., there is a
recession).

1
From Wikipedia, the free encyclopedia Circular flow of income

Five sector model lending of money. In terms of the circular

flow of income model the leakage that finan-
Table 1 All leakages and injections in five cial institutions provide in the economy is the
sector model option for households to save their money.
This is a leakage because the saved money
LEAKAGES INJECTION can not be spent in the economy and thus is
Saving (S) Investment (I) an idle asset that means not all output will be
Taxes (T) Government Spending (G) purchased. The injection that the financial
Imports (M) Exports (X) sector provides into the economy is invest-
ment (I) into the business/firms sector. An ex-
ample of a group in the finance sector in-
cludes banks such as Westpac or financial in-
stitutions such as Suncorp.
The next sector introduced into the circu-
lar flow of income is the Government Sector
that consists of the economic activities of loc-
al, state and federal governments. The leak-
age that the Government sector provides is
through the collection of revenue through
Taxes (T) that is provided by households and
firms to the government. For this reason they
are a leakage because it is a leakage out of
the current income thus reducing the ex-
penditure on current goods and services. The
injection provided by the government sector
is Government spending (G) that provides
collective services and welfare payments to
the community. An example of a tax collected
by the government as a leakage is income tax
and an injection into the economy can be
when the government redistributes this in-
come in the form of welfare payments, that is
a form of government spending back into the
economy.
The final sector in the circular flow of in-
come model is the overseas sector which
transforms the model from a closed economy
to an open economy. The main leakage from
this sector are imports (M), which represent
spending by residents into the rest of the
world. The main injection provided by this
sector is the exports of goods and services
which generate income for the exporters
from overseas residents. An example of the
Circular flow of income diagram use of the overseas sector is Australia export-
ing wool to China, China pays the exporter of
The five sector model of the circular flow the wool (the farmer) therefore more money
of income is a more realistic representation enters the economy thus making it an injec-
of the economy. Unlike the two sector model tion. Another example is China processing
where there are six assumptions the five sec- the wool into items such as coats and Aus-
tor circular flow relaxes all six assumptions. tralia importing the product by paying the
Since the first assumption is relaxed there Chinese exporter; since the money paying for
are three more sectors introduced. The first the coat leaves the economy it is a leakage.
is the Financial Sector that consists of banks In terms of the five sector circular flow
and non-bank intermediaries who engage in of income model the state of equilibrium
the borrowing (savings from households) and occurs when the total leakages are equal to

2
From Wikipedia, the free encyclopedia Circular flow of income

the total injections that occur in the eco- S + T + M > I + G + X the levels of in-
nomy. This can be shown as: come, expenditure and output will fall caus-
Savings + Taxes + Imports = Investment + ing a contraction or recession in the overall
Government Spending + Exports economic activity. As the income falls (Fig-
OR ure 4) households will cut down on all leak-
S + T + M = I + G + X. ages such as saving, they will also pay less in
This can be further illustrated through the taxation and with a lower income they will
fictitious economy of Noka where: spend less on imports. This will lead to a fall
S+T+M=I+G+X in the leakages until they equal the injections
$100 + $150 + $50 = $50 + $100 + $150 and a lower level of equilibrium will be the
$300 = $300 result.
Therefore since the leakages are equal to the The other equation of disequilibrium, if S
injections the economy is in a stable state of + T + M < I + G + X in the five sector model
equilibrium. This state can be contrasted to the levels of income, expenditure and output
the state of disequilibrium where unlike that will greatly rise causing a boom in economic
of equilibrium the sum of total leakages does activity. As the households income increases
not equal the sum of total injections. By giv- there will be a higher opportunity to save
ing values to the leakages and injections the therefore saving in the financial sector will
circular flow of income can be used to show increase, taxation for the higher threshold
the state of disequilibrium. Disequilibrium will increase and they will be able to spend
can be shown as: more on imports. In this case when the leak-
S+T+M≠I+G+X ages increase they will continue to rise until
Therefore it can be shown as one of the be- they are equal to the level injections. The end
low equations where: result of this disequilibrium situation will be
Total leakages > Total injections a higher level of equilibrium.
$150 (S) + $250 (T) + $150 (M) > $75 (I) +
$200 (G) + 150 (X)
Or
See also
Total Leakages < Total injections • History of economic thought
$50 (S) + $200 (T) + $125 (M) < $75 (I) + • Barter economy
$200 (G) + 150 (X) • Demand economy
The effects of disequilibrium vary according • Free-market economy
to which of the above equations they belong • Market
to.
If S + T + M > I + G + X the levels of in-
come, output, expenditure and employment
References
will fall causing a recession or contraction in [1] ^ Sloman, John. (1999), page 12
the overall economic activity. But if S + T + [2] Mankiw, Gregory. (2006), page 23
M < I + G + X the levels of income, output,
expenditure and employment will rise caus-
ing a boom or expansion in economic activity.
Further reading
To manage this problem, if disequilibrium 1. Sloman, John (1999). Economics, 3rd
were to occur in the five sector circular flow edition. Prentice Economics. Europe:
of income model, changes in expenditure and Prentice-Hall. ISBN 0273655744.
output will lead to equilibrium being re- 2. Mankiw, Gregory (2006). Principles of
gained. An example of this is if: Economics. Thomson Europe. ISBN
1844801330.

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Categories: Economics models

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