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
 Resource Income
Rs.
Productive Services

Businesses Households

Goods and Services

Rs.
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
 Resource Income

Loanable
Businesses 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
Third, the productionmarket
foreign exchange (GDP).
(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.