The Circular Flow Model

Circular Flow of Income

The cyclical operation of demand, output, income, and new demand
Leakages: flows out of circular flow when resource income is received and not spend directly on purchases from domestic firms Injections: Added spending in circular flow that does not come out of current resource income

Circular Flow - Simple Model

Resource Income

$$$
Productive Services

Businesses

Households

Goods and Services

$$$
Spending for Goods and Services

Stable Economy
If all income is spent business will sell all goods, and will be induced to produce all goods again

Flow with Leakages/Injections

Resource Income

Businesses

Loanable Investment Funds

Saving

Households

Spending

Government

Taxes

Spending for Goods and Services

Leakages and Injections

Leakages in the circular flow
savings taxes

Injections in the circular flow

investment government spending

Savings and Investment

If planned (I+G) = planned (S+T) so that injections = leakages and total spending = total income and demand = supply then we have a stable economy

Contracting Economy
If leakages are Higher than injections (Planned S+T > Planned I+G), economy contracts resulting in
inventory accumulation too little spending drop in prices

Expanding Economy
If injections are Higher than leakages (Planned I+G > Planned S+T), economy expands resulting in
more goods and services produced higher prices

Government and the Circular Flow

Balanced budget:
amount spent by government = amount collected in taxes

Surplus budget
amount spent by government = less than that collected in taxes

Deficit budget
amount spent by government = more than that collected in taxes

International Trade and the Circular Flow

IMPORTS are a leakage EXPORTS are an injection If exports = imports, the circular flow is in balance Usually it is not balanced
called a trade deficit, because imports (leakages) are greater than exports (injections)

The Circular Flow Diagram

The circular-flow diagram presents a visual model of the economy as coordinated by the four key markets. First, the resource market (bottom loop) coordinates the actions of businesses demanding resources and households supplying them in exchange for income. Second, the goods & services market (top loop) coordinates the demand
(consumption, investment, government purchases, and net-exports) for and supply of domestic production (GDP).

Third, the foreign exchange market (top right) brings the purchases (imports) from foreigners into balance with the sales (exports plus net inflow of capital) to them. Fourth, the loanable funds market (lower center) brings the net saving of households plus the net inflow of foreign capital into balance with the borrowing of businesses and governments.
by Harcourt, Inc Used by permission