Circular Flow of Income

Circular Flow of Income

The circular flow of income is a model that shows the interactions among economic agents in form of exchanges of money, resources, goods and services. The circular flow of income diagram can also measure the level of economic activities and explain why an economy might expand or contract. For example, there may be an inward flow of income from exports which increases the income flow in the economy. The purchase of imported products would reduce income flow in the economy because there is money leaves the economy as payments for imports. 

A two-sector economy
A two-sector economy is the simplest model and it is made up of two economic agents. The agents or participants are households and firms. The households, which comprise individuals, buy goods and services from the firms (businesses)  and make payments for those goods. The goods and services flow from the firms to households (see Figure 1 below). Money flow from households to firms as expenditure on goods and services (see Figure 1 below). Also, households supply firms with their productive resources (land, labour, capital and enterprise) in return for incomes which are rents, profits, interests, wages and salaries. 

This model assumes that all the income received by households is spent on goods and services and the same flow around the economy. Firms also pay out all money they receive from product sale as factor payments to domestic households.

Figure 1: A circular flow of income diagram for a two-sector economy without injection and leakage

A circular flow of income diagram for a two-sector economy without injection and leakage

In reality, not all incomes generated in the economy pass through the circular flow and not all incomes in the flow are generated locally. Some incomes are withdrawn from the income flow (withdrawals/leakages) while additional income may come from outside the economy (injections).


Injections
An injection is money introduced into the economy apart from that received from households when they purchase domestic goods and services from firms. The injections are investment, government spending and exports.

Investment entails spending by firms or businesses on capital goods, e.g. equipment, factories and raw materials. The money for investment is obtained from financial institutions as loans, drawdown of past savings or new share issues. Government spending is a source of additional income in the economy. The government spends on infrastructure like roads, education, communication network, etc. Some goods produced in the domestic economy are sold to consumers abroad by firms; incomes are received from abroad from exports.

Withdrawals
Withdrawals are incomes that are not allowed to move around the economy. They are removed from the circular flow and they are savings, taxes and imports. Withdrawals are also known as leakages.

Savings is part of income that is not spent by households but reserved for future use. It is usually kept in financial institutions. Taxes also reduce income and represent leakages from the income flow as the money is not available for spending on products by households. Money is withdrawn from the domestic economy and sent abroad for imported goods and services. 


A modified two-sector economy with injection and withdrawal

This is an improvement on the two-sector model. The injection in a two-sector economy is investment from firms (Figure 2 below). Money for investment is from financial institutions that obtain savings from economic units that have surplus funds and give them as loans to those economic units that need funds. The withdrawal or leakage here is savings, part of income that is not spent. 

Figure 2: A circular flow of income diagram for a two-sector economy with injection and leakage
A circular flow of income diagram for a two-sector economy without injection and leakage

A three-sector economy
A three-sector economy is made up of three players, namely households, firms and the government. The introduction of government means that there will be additional injection (government expenditure) and an additional withdrawal (taxes). Therefore, the injections in a three-sector economy are investment and government spending while the withdrawals are savings and taxes (Figure 3 below).

Figure 3: A circular flow of income diagram for a three-sector economy

A circular flow of income diagram for a three-sector economy
A four-sector economy

It comprises four sectors, namely households, firms, government and foreign sector. The foreign sector is the trade sector and it is made up of exports and imports. The injections in a four-sector economy are investment, government spending and exports; the leakages/withdrawals are savings, taxes and imports (Figure 4 below).

A two-sector or a three-sector economy is known as a closed economy while a four-sector economy is an open economy. A closed economy does not engage in foreign trade but an open economy is involved in trade with other countries. The four-sector economy is a model of a modern economy as there is no economy that is totally isolated from others in terms of trade.

 

Figure 4: A circular flow of income diagram for a four-sector economyA circular flow of income diagram for a four-sector economy
Circular flow of income and Gross Domestic Product (GDP)

The circular flow of income diagram also shows the level of economic activities or the output of the economy (GDP). GDP is measured by the output, income and expenditure methods. These three methods are shown on the circular flow of income diagram. Household expenditure on goods and services gives the GDP by the expenditure method; the goods and services flowing from firms to households produce the GDP by the output method while incomes paid to households by firms for use of productive resources amount to the GDP by income method (see Figure 5 below). The three methods should give the same value for the GDP of the country. Therefore, 
National Expenditure = National Output  = National Income

The national income in a two-sector economy is 
                         Y = C + I

A three-sector’s national income is calculated thus 
                        Y = C + I + G

The national income in a four-sector economy is given as
                         Y = C + I + G + (X-M)

Figure 5: A circular flow of income diagram showing different ways of measuring GDP

A circular flow of income diagram showing different ways of measuring GDP

Equilibrium of the national income
There is no tendency for the national income to change at equilibrium. This can occur when the injections and leakages in an economy are equal. 
In a two-sector economy, equilibrium occurs when
                         I = S
The equilibrium in a three-sector economy is given as:
                      I + G = S + T

Equilibrium in a four-sector economy is
                    I + G + X = S + T + M

Disequilibrium occurs when injections and withdrawals are not equal. If injections are greater than withdrawals, there is a net inflow of income into the economy. Total spending will rise and aggregate demand will expand. The economy’s output will increase as firms respond to the rise in aggregate demand. More incomes will be paid for the use of productive resources of land, labour, capital and enterprise following an increase in output. The unemployment rate will decrease even though inflationary pressure may build up as aggregate demand outpaces aggregate supply. A rise in domestic inflation would reduce the competitiveness of a country’s exports which may lead to a balance of payments deficit.

There is a net outflow of income if injections are lesser than withdrawals. More money will be removed from the income flow as a result of this. This will shrink aggregate demand and total expenditure in the economy. Jobs will be lost due to a reduction in output in the economy. And there may be deflationary pressure as prices keep falling.