CIRCULAR FLOW OF INCOME

The circular flow of income or circular flow is a model of the economy in

which
the
major
exchanges
are
represented
as
flows
of money, goods and services, etc. between economic agents. The flows of
money and goods exchanges in a closed circuit and correspond in value, but
run in the opposite direction. The circular flow analysis is the basis of national
accounts and hence of macroeconomics.
The circular flow of income and spending shows connections between
different sectors of an economy

It shows flows of goods and services and factors of production

between firms and households

The circular flow shows how national income or Gross Domestic

Product is calculated
Businesses produce goods and services and in the process of doing
so, incomes are generated for factors of production (land, labour, capital
and enterprise) for example wages and salaries going to people in work.
Leakages (withdrawals) from the circular flow
Not all income will flow from households to businesses directly. The circular
flow shows that some part of household income will be:

1.Put aside for future spending, i.e. savings (S) in banks accounts
and other types of deposit

2.Paid to the government in taxation (T) e.g. income tax and

national insurance

3.Spent on foreign-made goods and services, i.e. imports (M) which

flow into the economy
Withdrawals are increases in savings, taxes or imports so reducing the
circular flow of income and leading to a multiplied contraction of production
(output)
Types of models
Two sector model
In the basic circular flow of income, or two sector circular flow of income
model, the state of equilibrium is defined as a situation in which there is no
tendency for the levels of income (Y), expenditure (E) and output (O) to
change, that is:
Y=E=O

This means that the expenditure of buyers (households) becomes income for
sellers (firms). The firms then spend this income on factors of
production such as labour, capital and raw materials, "transferring" their
income to the factor owners. The factor owners spend this income on goods
which leads to a circular flow of income.
This basic circular flow of income model consists of six assumptions:
1. The economy consists of two sectors: households and firms.
2.

3.
4.
5.
6.

Households
spend
all
of
their income (Y)
on goods
and
services or consumption (C). There is no saving (S).
All output (O) produced by firms is purchased by households through
their expenditure (E).
There is no financial sector.
There is no government sector.
There is no foreign sector

Three sector model

It includes household sector, producing sector and government sector. It will
study a circular flow income in these sectors excluding rest of the world i.e.
closed economy income. Here flows from household sector and producing
sector to government sector are in the form of taxes. The income received
from the government sector flows to producing and household sector in the
form of payments for government purchases of goods and services as well as
payment of subsides and transfer payments. Every payment has a receipt in
response of it by which aggregate expenditure of an economy becomes
identical to aggregate income and makes this circular flow unending.

Four sector model

A modern monetary economy comprises a network of four sector economy
these are:

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1.
2.
3.
4.

Household sector
Firms or Producing sector
Government sector
Rest of the world sector.

Each of the above sectors receives some payments from the other in lieu of
goods and services which makes a regular flow of goods and physical
services. Money facilitates such an exchange smoothly. A residual of each
market comes in capital market as saving which inturn is invested in firms
and government sector. Technically speaking, so long as lending is equal to
the borrowing i.e. leakage is equal to injections, the circular flow will continue
indefinitely. However this job is done by financial institutions in the economy.
Five sector model
In the five sector model the economy is divided into five sectors:
1. Household sector
2. Firms or Producing sector
3. Financial sector : banks and non-bank intermediaries who engage in
the borrowing (savings from households) and lending of money
4. Government sector : consists of the economic activities of local, state
and federal governments.
5. Rest of the world sector: transforms the model from a closed
economy to an open economy.
The five sector model of the circular flow of income is a more realistic
representation of the economy. Unlike the two sector model where there are
six assumptions the five sector circular flow relaxes all six assumptions. Since
the first assumption is relaxed there are three more sectors introduced.

Circular flow of income topics

Leakage and injections
In the five sector model the economy there is leakage and injections

Leakage means withdrawal from the flow. When households and firms
save part of their incomes it constitutes leakage. They may be in form of
savings, tax payments, and imports. Leakages reduce the flow of income.
injections means introduction of income into the flow.When
households
and
firms
borrow
the
savings,they
constitute
injections.Injections increase the flow of income.Injections can take the
forms of (a) investment,(b) government spending and (c) exports.So long
as leakages are equal to injections circular flow of income continues
indefinitely.Financial institutions or capital market play the role of
intermediaries.

Leakage and injections can occur in the financial sector, government sector
and overseas sector:
In the financial sector
In terms of the circular flow of income model the leakage that financial
institutions provide in the economy is the option for households to save their
money. This is a leakage because the saved money can not be spent in the
economy and thus is an idle asset that means not all output will be
purchased. The injection that the financial sector provides into the economy
is investment (I) into the business/firms sector. An example of a group in the
finance sector includes banks such as Westpac or financial institutions such
as Suncorp.
In the government sector
The leakage 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 expenditure 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 income in the form of welfare payments, that is a form of
government spending back into the economy.
In the overseas sector
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

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exporters from overseas residents. An example of the use of the overseas

sector is Australia exporting wool to China, China pays the exporter of the
wool (the farmer) therefore more money enters the economy thus making it
an injection. Another example is China processing the wool into items such as
coats and Australia importing the product by paying the Chinese exporter;
since the money paying for the coat leaves the economy it is a leakage.

S + T + M = I + G + X.

Summary of leakage and injections

LEAKAGES
INJECTION
Saving (S)

Investment (I)

Taxes (T)

Government Spending (G)

Imports (M)
Exports (X)
Table 1 All leakages and injections in five sector model
The state of equilibrium
In terms of the five sector circular flow of income model the state of
equilibrium occurs when the total leakages are equal to the total injections
that occur in the economy. This can be shown as:
Savings + Taxes + Imports = Investment + Government Spending + Exports
OR

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