From Wikipedia, the free encyclopedia Circular flow of income

Circular flow of income

More complete and realistic circular flow
models are more complex. They would expli-
citly include the roles of government and fin-
ancial markets, along with imports and
exports.
Labor and other "factors of production"
are sold on resource markets. These re-
sources, purchased by firms, are then used to
produce goods and services. The latter are
sold on product markets, ending up in the
hands of the households, helping them to
supply resources.

In this simplified image, the relationship

between the decision-makers in the circular Assumptions
flow model is shown. Larger arrows show The basic circular flow of income model con-
primary factors, whilst the red smaller ar-
sists of six assumptions:
rows show subsequent or secondary factors.
1. The economy consists of two sectors:
households and firms.
In economics, the term circular flow of in-
2. Households spend all of their income (Y)
come or circular flow refers to a simple
on goods and services or consumption (C).
economic model which describes the recip-
There is no saving (S).
rocal circulation of income between produ-
3. All output (O) produced by firms is
cers and consumers.[1][2] In the circular flow
purchased by households through their
model, the inter-dependent entities of produ-
expenditure (E).
cer and consumer are referred to as "firms"
4. There is no financial sector.
and "households" respectively and provide
5. There is no government sector.
each other with factors in order to facilitate
6. There is no overseas sector.
the flow of income[1]. Firms provide con-
sumers with goods and services in exchange
for consumer expenditure and "factors of pro- Two Sector Model
duction" from households.
In the simple two sector circular flow of
The circle of money flowing through the
income model the state of equilibrium is
economy is as follows: total income is spent
defined as a situation in which there is no
(with the exception of "leakages" such as
tendency for the levels of income (Y), ex-
consumer saving), while that expenditure al-
penditure (E) and output (O) to change, that
lows the sale of goods and services, which in
is:
turn allows the payment of income (such as
Y=E=O
wages and salaries). Expenditure based on
This means that the expenditure of buyers
borrowings and existing wealth – i.e., "injec-
(households) becomes income for sellers
tions" such as fixed investment – can add to
(firms). The firms then spend this income on
total spending.
factors of production such as labour, capital
In equilibrium (Preston), leakages equal
and raw materials, "transferring" their in-
injections and the circular flow stays the
come to the factor owners. The factor owners
same size. If injections exceed leakages, the
spend this income on goods which leads to a
circular flow grows (i.e., there is economic
circular flow of income.
prosperity), while if they are less than leak-
ages, the circular flow shrinks (i.e., there is a
recession).

1
From Wikipedia, the free encyclopedia
Five sector model
Table 1 All leakages and injections in five
sector model
LEAKAGES INJECTION
Saving (S) Investment (I)
Taxes (T) Government Spending (G) purchased. The injection that the financial
Imports (M) Exports (X)
Circular flow of income diagram
The five sector model of the circular flow the wool (the farmer) therefore more money
of income is a more realistic representation
of the economy. Unlike the two sector model
where there are six assumptions the five sec- the wool into items such as coats and Aus-
tor circular flow relaxes all six assumptions. tralia importing the product by paying the
Since the first assumption is relaxed there
are three more sectors introduced. The first
is the Financial Sector that consists of banks
and non-bank intermediaries who engage in
the borrowing (savings from households) and
2
Circular flow of income
lending of money. In terms of the circular
flow of income model the leakage that finan-
cial 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
sector provides into the economy is invest-
ment (I) into the business/firms sector. An ex-
ample of a group in the finance sector in-
cludes banks such as Westpac or financial in-
stitutions such as Suncorp.
The next sector introduced into the circu-
lar flow of income is the Government Sector
that consists of the economic activities of loc-
al, state and federal governments. The leak-
age 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 ex-
penditure 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 in-
come in the form of welfare payments, that is
a form of government spending back into the
economy.
The final sector in the circular flow of in-
come model is the overseas sector which
transforms the model from a closed economy
to an open economy. 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 exporters
from overseas residents. An example of the
use of the overseas sector is Australia export-
ing wool to China, China pays the exporter of
enters the economy thus making it an injec-
tion. Another example is China processing
Chinese exporter; since the money paying for
the coat leaves the economy it is a leakage.
In terms of the five sector circular flow
of income model the state of equilibrium
occurs when the total leakages are equal to
From Wikipedia, the free encyclopedia
the total injections that occur in the eco-
nomy. This can be shown as:
Savings + Taxes + Imports = Investment +
Government Spending + Exports
OR
S + T + M = I + G + X.
This can be further illustrated through the
fictitious economy of Noka where:
S+T+M=I+G+X
$100 + $150 + $50 = $50 + $100 + $150
$300 = $300
Therefore since the leakages are equal to the
injections the economy is in a stable state of
equilibrium. This state can be contrasted to
the state of disequilibrium where unlike that
of equilibrium the sum of total leakages does
not equal the sum of total injections. By giv-
ing values to the leakages and injections the
circular flow of income can be used to show
the state of disequilibrium. Disequilibrium
can be shown as:
S+T+M≠I+G+X
Therefore it can be shown as one of the be-
low equations where:
Total leakages > Total injections
$150 (S) + $250 (T) + $150 (M) > $75 (I) +
$200 (G) + 150 (X)
Or
Total Leakages < Total injections
$50 (S) + $200 (T) + $125 (M) < $75 (I) +
$200 (G) + 150 (X)
The effects of disequilibrium vary according
to which of the above equations they belong
to.
If S + T + M > I + G + X the levels of in-
come, output, expenditure and employment
will fall causing a recession or contraction in
the overall economic activity. But if S + T +
M < I + G + X the levels of income, output,
expenditure and employment will rise caus-
ing a boom or expansion in economic activity.
To manage this problem, if disequilibrium
were to occur in the five sector circular flow
of income model, changes in expenditure and
output will lead to equilibrium being re-
gained. An example of this is if:
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Circular flow of income
S + T + M > I + G + X the levels of in-
come, expenditure and output will fall caus-
ing a contraction or recession in the overall
economic activity. As the income falls (Fig-
ure 4) households will cut down on all leak-
ages such as saving, they will also pay less in
taxation and with a lower income they will
spend less on imports. This will lead to a fall
in the leakages until they equal the injections
and a lower level of equilibrium will be the
result.
The other equation of disequilibrium, if S
+ T + M < I + G + X in the five sector model
the levels of income, expenditure and output
will greatly rise causing a boom in economic
activity. As the households income increases
there will be a higher opportunity to save
therefore saving in the financial sector will
increase, taxation for the higher threshold
will increase and they will be able to spend
more on imports. In this case when the leak-
ages increase they will continue to rise until
they are equal to the level injections. The end
result of this disequilibrium situation will be
a higher level of equilibrium.
See also
• History of economic thought
• Barter economy
• Demand economy
• Free-market economy
• Market
References
[1] ^ Sloman, John. (1999), page 12
[2] Mankiw, Gregory. (2006), page 23
Further reading
1. Sloman, John (1999). Economics, 3rd
edition. Prentice Economics. Europe:
Prentice-Hall. ISBN 0273655744.
2. Mankiw, Gregory (2006). Principles of
Economics. Thomson Europe. ISBN
1844801330.