Introduction to the

circular flow of income

The circular flow of income

• The circular flow of income shows the relationship between

households, firms, the government and the foreign trade sector.
• The circular flow of closed economy
• A simple model of the economy in which there are only two sectors
i.e. households and firms are included.
 contd’
Income: wages, interest, profits, rent

Factor services

Firms
Households

Consumers goods & services

Consumption spending
• Firms are producing units which hire services of households. For these
services firms pay rent, wages, interest and profit (dividends).

• Therefore there is a flow of factor services from households to firms

and a flow of income from firms to households.
• These flows are represented by the upper arrows.
• Likewise, households are also the purchasers of the national output.
• So there is a flow of spending from households to firms and a flow of
goods and services from firms to households. The flows are
represented by the lower arrows.
• The costs of production represent the income paid to households.
Three sector model
• Three sector model involves firms, household and government sector
in economic activity. It is also closed model. Here injections include
investment , consumption and government expenditure and leakages
include savings from households and firms and tax revenue of
government.
Leakages and injections

• This model (two sector or simple) is unrealistic because even in the

simplest economy all the incomes received by the households is not
spent, some of it, is saved.
• Savings represent leakage or withdrawal from the circular flow of
income because it is part of the income paid by the firms which is not
returned to them through the spending of households.
• When saving takes place, firms expenses will be greater than their
receipts and some of their output will remain unsold.
• So that income and output will fall.
• If households always save some parts of their income and there is no
other expenditure to offset this leakage, income must eventually fall
to zero.
• Generally there is an offsetting expenditure in the form of investment.
• This model assumed that firms only produce consumer goods and
services which in turn bought by households.
• In fact some firms produce capital goods for sale to other firms. This
expenditure on capital goods adds to the circular flow, it has positive
effect to an injection. Investment is an injection to the circular flow of
income.
• The following figure shows this,
This figure shows the saving as
leakage and the investment as
injection.
Income

Firms Households Saving

Investment

Consumption
A more realistic model ( open
economy)
• To make more realistic model, it is necessary to include the government
and foreign trade sectors in determining the level of economic activity
• Foreign trade
• Some parts of the expenditure of household don't flow back to
domestic firms because households buy foreign products.
• These imports are leakages from the circular flow because the income
paid by the firms to households doesn’t flow back to them.
• Exports are injections into a circular flow because this spending by
foreigners to home produced output is an additional source of income
which is not generated within the domestic system.
• If X>M, there will be an expansionary effect on income.
• If X<M, there will have a depressing effect on income.
• Government
• Government spending takes several forms. Government spending on
goods and services is an injection because it adds to real output and
creates employment.
• Transfer payments do not directly generate output and income.
• Government transfers existing income from taxpayers to the
recipients of the benefits.

• Taxes are the leakage because they remove purchasing power from
the system.

• The importance of govt. spending and taxation lies in the fact that
they can deliberately manipulated to influence the level of output and
employment.
• A budget deficit (govt. spending> tax) will have an expansionary effect
and a budget surplus a depressing effect on income.

• The following figure shows the picture of the circular flow of income
which takes into account all four sectors.
 Income
Saving
Investment

Govt. Spending Firms Households Taxes

Exports Imports

Consumption
• In the figure, all leakages originate at the household sectors.
• In reality, the same leakages take place from other sectors also such
as firms also pay taxes on their income, they save profits as well as
they buy foreign materials and machines .
• If all leakages and injections are included, the figure would become
more complicated.
The impact of injections and
leakages on the circular flow
• In practice, there are leakages out of the circular flow – some income
is saved, some is taxed and some is spent on imports. Some
expenditure is also additional to the spending that comes from the
incomes generated by domestic output.
• These extra items of spending, known as injections, are investment,
government spending and spending by foreigners on a country’s
exports. The following figure includes these leakages, also known as
withdrawals, and the injections, in a circular flow of income diagram
of an open economy.
 Circular Flow of Income in an
Open Economy/ four sector model
Import
Govt Spending
Indirect Taxes
Spending on Goods & services

Households Goods & Services Firms

Factor Services
Factor Payments
Direct Taxes Export
Savings Govt Spending
ACTIVITY 16.1
• The extent to which economies trade with other countries varies. For
example, Singapore is a very open economy. It has the highest
international trade-to-GDP ratio in the world. In contrast, Burundi, a
landlocked African country, is a more closed economy. It exports only
5% of its output but imports 25% of the products it consumes.
• 1 How open is your economy?
• 2 Explain how an economy opening up to international trade may
affect its circular flow of income.
• 3 What sources did you use to answer question 1? Did the
information on Burundi help you with your answer to the question 2?
Income determination
• The level of income of an economy is determined where AE= output
• If AE exceeds current output, firms will seek to increase production. It
develops the situation where firms have to employ more factor inputs
and will cause GDP to rise.
Equilibrium and disequilibrium
income
For income to be unchanged, injections of extra spending into the
circular flow of income must equal leakages from the circular flow. If
injections are greater than leakages, there will be extra spending in the
economy, causing income to rise.
In contrast, if leakages exceed injections, more spending will leave the
circular flow, and income will fall.
Figure 9.18 shows equilibrium income in a closed economy without a
government. Such an economy has only two sectors: households and
firms.
A rise in investment would cause a rise in
GDP. It is shown in the figure 9.19 below:

The investment function is drawn

as a horizontal line because
investment is based on interest
rates and expectations about the
future, and so it does not change
with the level of current national
income. However, changes in
factors like technological
opportunities, expectations about
near-term economic growth, and
interest rates would all cause the
investment function to shift up or
down.
• The investment function is drawn as a horizontal line in the above
diagram because it is based on interest rates and expectations about
the future, and so it does not change with the level of current
national income at a particular time period .
• However, over a period of time, changes in factors like technological
opportunities, expectations about near-term economic growth, and
interest rates would all cause the investment function to shift up or
down.
• Equilibrium income in an open economy ( four sector economy)
• It includes all four sectors i.e. household, firms, government and
foreign trade sector.
• The diagram 9.20 shows the equilibrium income at that point where
all leakages are equal to all injections.
• The impact of a rise in
taxation
• The impact of a rise in
taxation on equilibrium
income is that, the total GDP
will decrease. It is shown in
the figure 9.21
• Paradox of thrift
• A rise in savings will cause GDP to fall. Indeed, a decision by
household to save more can result in them saving less.
• This is because higher saving can reduce income and hence the ability
to save by households. This is referred to as Paradox of thrift.
• When people start to
save a large proportion
of their income, the
result of which is a fall
in aggregate demand
that will eventually
produce a fall in the
level of savings.
• It is shown in the
figure 8.14
Answers
• 1 a Households buy products from firms and firms sell products to
households.
• b Households as factors of production sell their services to firms and
firms pay for their services.
Answer 2
Closed economy without Closed economy with Open economy with
government government government

Economic agents Firms and households Firms households and Firms households
government government and foreign
trade
Injections Investment Investment and govt. Investment, govt.
expenses expenses and exports

Leakages Savings Savings and taxation Saving, taxations and

imports