Circular Flow of Income

There are two cycles 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.

These two cycles give an overview of how an economy works: if you want to pay for goods and services, you need to exchange money for them. And to pay for what you want, you need to earn income. In this explanation, you learn about the circular flow of income model that explains the idea above.

What is 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

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

Figure 1. Circular flow of income, StudySmarter Original

Types of 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 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 products and services are produced and consumed in the economy.

The money flow is the transfer of 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 investment, 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 to save part of their income.
2. Consumers purchase all output created by companies through their consumption.

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

Figure 2. Two-sector circular flow of income model, StudySmarter Original

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

In the three-sector circular flow model, the government is added to the basic circular flow model (two-sector 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

Figure 3. Three-sector circular flow of income, StudySmarter Original

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

Figure 4. Four-sector circular flow of income model, StudySmarter Original

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 is made up of 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, which results in the generation of lower incomes and national revenue. Financial institutions in the economy, on the other hand, 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

Figure 5. Five-sector circular flow of income model, StudySmarter Original

Leakages and Injections in the Circular Flow of Income

A glance at the circular flow model reveals that while the sectors such as individuals and firms pump money into the economy, other agents withdraw it. This is the key concept of leakages and injections that balance the circular flow of economic activities. The cyclic flow of money will continue as long as leakages equal injections (see Figure 5).

The government sector contributes to leakages by collecting income from individuals and businesses through taxes (T). This is a leakage because it lowers the households’ spending on goods and services. Government expenditure (G), which provides public services and welfare payments to the community, on the other hand, is the injection into the circular flow.

Circular flow of income equilibrium

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 a state of 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.