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Circular Flow Of Income !!

S u ve n d u B a r i k
 Circular Flow Of Income
The circular flow of income is a neoclassical
economic model depicting how money flows
through the economy.
In the most simple version, the economy is modeled
as consisting only of households and firms.
Money flows to workers in the form of wages, and
money flows back to firms in exchange for products.
This simplistic model suggests the old economic
belief, "Supply creates its own demand."

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2 Sector Model

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 Households

The primary economic function of households is to

supply domestic firms with needed factors of production
- land, human capital, real capital and enterprise.
The factors are supplied by factor owners in return for a
reward.
Land is supplied by landowners,
Human capital by labour,
Real capital by capital owners (capitalists) and
Enterprise is provided by entrepreneurs.

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 Firms

The function of firms is to

supply private goods and
services to domestic
households and firms, and to
households and firms abroad.
To do this they use factors
and pay for their services.

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 Injections and Withdrawals
The circular flow will adjust following new injections into it or new withdrawals
from it. An injection of new spending will increase the flow. A net injection
relates to the overall effect of injections in relation to withdrawals following a
change in an economic variable.

The simple circular flow is, therefore, adjusted to take into account
withdrawals and injections. Households may choose to save (S) some of their
income (Y) rather than spend it (C), and this reduces the circular flow of
income. Marginal decisions to save reduce the flow of income in the economy
because saving is a withdrawal out of the circular flow. However, firms also
purchase capital goods, such as machinery, from other firms, and this
spending is an injection into the circular flow. This process, called investment
(I), occurs because existing machinery wears out and because firms may
wish to increase their capacity to produce.

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3 Sector Model
 The public sector
In a mixed economy with a government, the simple model must be adjusted
to include the public sector.
Therefore, as well as save, households are also likely to pay taxes (T) to the
government (G),
and further income is withdrawn out of the circular flow of income.
Government injects income back into the economy by spending (G) on public
and merit goods like defense and policing, education, and healthcare, and
also on support for the poor and those unable to work.

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4 Sector Model

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ALL IN ONE CIRCULAR FLOW

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Injections and Leakage

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 International trade
Finally, the model must be adjusted to include
international trade. Countries that trade are called ‘open’
economies, the households of an open economy will
spend some of their income on goods from abroad,
called imports (M), and this is withdrawn from the
circular flow.
Foreign consumers and firms will, however, also wish to
buy domestic products, called exports (X), and this is an
injection into the circular flow.

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 2 to 5 Sector Model

The circular flow of income model illustrates the

interdependencies of different factors in the
economy. However, actual money flows through
the economy are far more complicated.
Economists have expanded on the ideas of the
circular flow of income model to better depict the
complexity of modern economies

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