The Circular-Flow of Income

Circular Flow of Income

 Because land, labor, and capital are

generally owned by households, firms
must pay for their use
 This payment, along with profits, become
income and purchasing power that can
be used to buy goods and services
 These payments are referred to as
resource income
 Circular Flow of Income
 The demand for goods and services by the
recipients of resource income leads to more
output, which in turn brings about
additional payments of resource income
 This cyclical operation of demand, output,
income, and new demand is illustrated by
the circular flow of income diagram
 The size of the circular flow measures the
level of income and output in the economy
 The Circular-Flow Diagram
Revenue Market for Spending
Goods
Goods & Goods &
Services sold and Services Services bought

Firms
Households

Labor, land,
Inputs for capital &
production Market for
Entrepreneur
Factors
Wages, rent, , rate of of Production Income
interest & profit
 Leakages
 Resource income and spending are
not always equal because of leakages
 Flows out of the circular flow that
occur when resource income is
received and not spent directly on
purchases from domestic firms
 Saving
 Taxes
 Injections
 However, at least some of these
leakages are returned to the circular
flow via various injections
 Added spending in the circular flow
that is not paid for out of current
resource income
 Investment
 Government spending,
 Exports bought by foreign buyers
 Savings and Investment

 Leakage in the circular flow

 Saving
 Injection in the circular flow
 Investment
Spending to purchase capital goods
 Three Sector Model – Government
Include in Circular Flow
 In a three sector model the Government sector is
included as part of the circular flow model
 How does the Government affect the equilibrium
in the circular flow model?
1) Withdraw amounts from the circular flow through taxes
(T) – transfer payments
2) Inject amounts into the circular flow through
government purchases - expenditure
 These Government actions affect both Households
and Firms
 Three Sector Model – Government
Include in Circular Flow
 Points to note:
 Taxes gain by Government is the net of taxes after transfers
has been deducted
 That is: Net taxes = T = Taxes – Transfer payments
 Why transfer payments are not included in government
purchases?
– transfer payments do not require that the recipient produce a good
or service in order to receive them
– examples of transfers payments include social security, welfare,
and unemployment benefits
– these are regarded as compensation and are not counted in
government purchases
 Three Sector Model – Government
Include in Circular Flow
 Points to note:
 Transfer payments and government purchases are both
parts of government spending

 But government purchases are represented on a circular

flow diagram as flows of money from government to
firms and goods and services from firms to government

 Government Purchases - are the sum of purchases of

goods and services from firms by government agencies,
plus the total value of output produced by government
agencies
Three Sector Model – Government
Include in Circular Flow
 Four Sector Model – Foreign Sector
Include in Circular Flow
 In a four sector model the Foreign sector is
included as part of the circular flow model

 How does the Foreign sector affect the

equilibrium in the circular flow model?
1) Withdraw amounts from the circular flow through
import payments (M)
2) Inject amounts into the circular flow through export
receipts (X)
 Four Sector Model – Foreign Sector
Include in Circular Flow
Withdrawal
Loans for
investment Producers
Banks
consumer spending (C)
Savings (S) Export receipts (X)
Purchases/spending (G)

Transfers Taxes
Firms
Foreign
Household Government Sector
s Taxes Subsidies
Import payments (M)

Factor income – wages, profits

etc (Y)
Four Sector Model – Foreign Sector
Include in Circular Flow
Government and the Circular
Flow
 A balanced budget
 The amount spent by the government =
The amount collected in taxes
 A surplus budget
 The amount spent by the government <
amount collected in taxes
 A deficit budget
 The amount spent by the government >
amount collected in taxes