Circular flow of income

The circular flow of income or circular flow is a model of the economy in which the major
exchanges are represented as flows of money, goods and services, etc. between economic agents.
The flows of money and goods exchanged in a closed circuit correspond in value, but run in the
opposite direction. The circular flow analysis is the basis of national accounts and hence of
macroeconomics.

This graph shows the circular flow of income in a five-sector

economy. The flow of money is shown with purple, and the flow of
goods and services is shown with orange. Money flows in the
opposite direction from goods and services.[1]
 Basic diagram of the circular flow of income. The functioning
of the free-market economic system is represented with firms
and households and interaction back and forth.[2]

The idea of the circular flow was already present in the work of Richard Cantillon.[3] François
Quesnay developed and visualized this concept in the so-called Tableau économique.[4] Important
developments of Quesnay's tableau were Karl Marx's reproduction schemes in the second volume
of Capital: Critique of Political Economy, and John Maynard Keynes' General Theory of Employment,
Interest and Money. Richard Stone further developed the concept for the United Nations (UN) and
the Organisation for Economic Co-operation and Development to the system, which is now used
internationally.

Overview

Model of the circular flow of income and expenditure

The circular flow of income is a concept for better understanding of the economy as a whole and for
example the National Income and Product Accounts (NIPAs). In its most basic form it considers a
simple economy consisting solely of businesses and individuals, and can be represented in a so-
called "circular flow diagram." In this simple economy, individuals provide the labour that enables
businesses to produce goods and services. These activities are represented by the green lines in the
diagram.[5]

Alternatively, one can think of these transactions in terms of the monetary flows that occur.
Businesses provide individuals with income (in the form of compensation) in exchange for their
labor. That income is spent on the goods and services businesses produce. These activities are
represented by the blue lines in the diagram above.[5]

The circular flow diagram illustrates the interdependence of the “flows,” or activities, that occur in
the economy, such as the production of goods and services (or the “output” of the economy) and
the income generated from that production. The circular flow also illustrates the equality between
the income earned from production and the value of goods and services produced.[5]

Of course, the total economy is much more complicated than the illustration above. An economy
involves interactions between not only individuals and businesses, but also Federal, state, and local
governments and residents of the rest of the world. Also not shown in this simple illustration of the
economy are other aspects of economic activity such as investment in capital (produced—or fixed—
assets such as structures, equipment, research and development, and software), flows of financial
capital (such as stocks, bonds, and bank deposits), and the contributions of these flows to the
accumulation of fixed assets.[5]

History

Cantillon

Representation of Cantillon's primitive circular

flow model[6]

One of the earliest ideas on the circular flow was explained in the work of 18th century Irish-French
economist Richard Cantillon,[3] who was influenced by prior economists, especially William Petty.[7]
Cantillon described the concept in his 1730 Essay on the Nature of Trade in General, in chapter 11,
entitled "The Par or Relation between the Value of Land and Labor" to chapter 13, entitled "The
Circulation and Exchange of Goods and Merchandise, as well as their Production, are Carried On in
Europe by Entrepreneurs, and at a Risk." Thornton eds. (2010) further explained:

Cantillon develops a circular-flow model of the economy that shows the distribution of farm
production between property owners, farmers, and workers. Farm production is exchanged for the
goods and services produced in the cities by entrepreneurs and artisans. While the property owners
are “independent,” the model demonstrates the mutual interdependence between all the classes of
people that Adam Smith dubbed the “invisible hand” in The Theory of Moral Sentiments (1759).[8]
Cantillon distinguished at least five types of economic agents: property owners, farmers,
entrepreneurs, labors and artisans, as expressed in the contemporary diagram of the Cantillon's
Circular Flow Economy.[6]

Quesnay

Tableau économique

François Quesnay further developed these concepts, and was the first to visualize these interactions
over time in the so-called Tableau économique.[4] Quesnay believed that trade and industry were not
sources of wealth, and instead in his 1758 book Tableau économique (Economic Table) argued that
agricultural surpluses, by flowing through the economy in the form of rent, wages, and purchases
were the real economic movers, for two reasons.

First, regulation impedes the flow of income throughout all social classes and therefore economic
development.
 Second, taxes on the productive classes such as farmers should be reduced in favor of higher
taxes for unproductive classes such as landowners, since their luxurious way of life distorts the
income flow.

The model Quesnay created consisted of three economic agents: The "Proprietary" class consisted
of only landowners. The "Productive" class consisted of all agricultural laborers. The "Sterile" class
is made up of artisans and merchants. The flow of production and/or cash between the three
classes started with the Proprietary class because they own the land and they buy from both of the
other classes. Quesnay visualised the steps in the process in the Tableau économique.

Marx

In Marxian economics, economic reproduction refers to recurrent (or cyclical) processes[9] by which
the initial conditions necessary for economic activity to occur are constantly re-created.[10]

Economic reproduction involves the physical production and distribution of goods and services, the
trade (the circulation via exchanges and transactions) of goods and services, and the consumption
of goods and services (both productive or intermediate consumption and final consumption).

Karl Marx developed the original insights of Quesnay to model the circulation of capital, money, and
commodities in the second volume of Das Kapital to show how the reproduction process that must
occur in any type of society can take place in capitalist society by means of the circulation of
capital.[11]

Marx distinguishes between "simple reproduction" and "expanded (or enlarged) reproduction".[12] In
the former case, no economic growth occurs, while in the latter case, more is produced than is
needed to maintain the economy at the given level, making economic growth possible. In the
capitalist mode of production, the difference is that in the former case, the new surplus value
created by wage-labour is spent by the employer on consumption (or hoarded), whereas in the latter
case, part of it is reinvested in production.
Further developments

The competitive price system

adapted from Samuelson, 1961

An important development was John Maynard Keynes's 1933 publication of the General Theory of
Employment, Interest and Money. Keynes' assistant Richard Stone further developed the concept for
the United Nations (UN) and the Organisation for Economic Co-operation and Development to the
systems, which is now used internationally.

The first to visualize the modern circular flow of income model was Frank Knight in 1933 publication
of The Economic Organization.[13] Knight (1933) explained:

[we may view the] economic organization as a system of prize relations. Seen in the large, free
enterprise is an organization of production and distribution in which individuals or family units get
their real income, their "living," by selling productive power for money to "business units" or
"enterprises", and buying with the money income thus obtained the direct goods and services which
they consume. This view, it will be remembered, ignores for the sake of simplicity the fact that an
appreciable fraction of the productive power in use at any time is not really employed in satisfying
current wants but to make provision for increased want-satisfaction in the future; it treats society as
it would be, or would tend to become, with progress absent, or in a "static" state.[14]

Knight pictured a circulation of money and circulation of economic value between people
(individuals, families) and business enterprises as a group,[15] explaining: "The general character of
an enterprise system, reduced to its very simplest terms, can be illustrated by a diagram showing
the exchange of productive power for consumption goods between individuals and business units,
mediated by the circulation of money, and suggesting the familiar figure of the wheel of wealth."[16]

Types of models

A circular flow of income model is a simplified representation of an economy.[2]

Two-sector model

Two-sector circular flow diagram

In the basic two-sector circular flow of income model, the economy consists of two sectors: (1)
households and (2) firms.[17][18] (Some sources refer to households as "individuals"[19] or the
"public"[20] and to firms as "businesses"[1][2] or the "productive sector."[21]) The model assumes that
there is no financial sector, no government sector, and no foreign sector. In addition, the model
assumes that (a) through their expenditures, households spend all of their income on goods and
services or consumption and (b) through their expenditures, households purchase all output
produced by firms.[18] This means that all household expenditures become income for firms. The
firms then spend all of this income on factors of production such as labor, capital and raw materials,
"transferring" all of their income to the factor owners (which are households). The factor owners
(households), in turn, spend all of their income on goods, which leads to a circular flow of
income.[20][18][22]

Three-sector model

Three-sector circular flow diagram

The three-sector model adds the government sector to the two-sector model.[17][18] Thus, the three-
sector model includes (1) households, (2) firms, and (3) government. It excludes the financial sector
and the foreign sector. The government sector consists of the economic activities of local, state and
federal governments. Flows from households and firms to government are in the form of taxes. The
income the government receives flows to firms and households in the form of subsidies, transfers,
and purchases of goods and services.[17][18] Every payment has a corresponding receipt; that is,
every flow of money has a corresponding flow of goods in the opposite direction.[17][18] As a result,
the aggregate expenditure of the economy is identical to its aggregate income, making a circular
flow.

Four-sector model

The four-sector model adds the foreign sector to the three-sector model.[17][18][23] (The foreign
sector is also known as the "external sector," the "overseas sector,"[19] or the "rest of the world.")
Thus, the four-sector model includes (1) households, (2) firms, (3) government, and (4) the rest of
the world. It excludes the financial sector. The foreign sector comprises (a) foreign trade (imports
and exports of goods and services) and (b) inflow and outflow of capital (foreign exchange).[18]
Again, each flow of money has a corresponding flow of goods (or services) in the opposite
direction.[18] Each of the four sectors receives some payments from the other in lieu of goods and
services which makes a regular flow of goods and physical services. The addition of the foreign
sector

Five-sector model

The five-sector model adds the financial sector to the four-sector model.[19] Thus, the five-sector
model includes (1) households, (2) firms, (3) government, (4) the rest of the world, and (5) the
financial sector. The financial sector includes banks and non-bank intermediaries that engage in
borrowing (savings from households) and lending (investments in firms).[19] Money facilitates such
an exchange smoothly. Residuals from each market enter the capital market as savings, which in
turn are invested in firms and the government sector. Technically speaking, so long as lending is
equal to borrowing (i.e., leakages are equal to injections), the circular flow will continue indefinitely.
However, this job is done by financial institutions in the economy.

Five-sector circular Circular flow diagram,

flow of income model five-sectors model
Alternative models

The progression from the two-sector model to the five sector model as documented above (that is,
by starting with households and firms, then successively adding the government sector, the foreign
sector, and the financial sector) is common. However, some authors group (1) households, (2) firms,
and (3) the financial sector together as the "private sector" and subsequently add (4) the
government sector, making the "domestic sector," and (5) the foreign sector.[19] Others use the
"capital market" rather than the "financial sector" to account for the flows of savings and
investments; in these sources, the fully specified model has four sectors (households, firms,
government, and foreign) plus the capital market, which is regarded as a market rather than a
sector.[18]

Circular flow of income topics

Leakages and injection

The five-sector model considers leakages and injections.

'Leakage' means withdrawal from the flow. When households and firms save part of their incomes
it constitutes leakage. They may be in form of savings, tax payments, and imports. Leakages
reduce the flow of income.

'Injection' means the introduction of income into the flow. When households and firms borrow
savings, they constitute injections. Injections increase the flow of income. Injections can take the
forms of investment, government spending and exports. As long as leakages are equal to
injections, the circular flow of income continues indefinitely. Financial institutions or capital
market play the role of intermediaries. This means that income individuals receive from
businesses and the goods and services that are sold to them do not count as injections or
leakages, as no new money is being introduced to the flow and no money is being taken out of the
flow.

Leakages and injections can occur in the financial sector, government sector and overseas sector:

In the financial sector

In terms of the circular flow of income model, the leakage that financial institutions provide in the
economy is the option for households to save their money. This is a leakage because the saved
money cannot be spent in the economy and thus is an idle asset that means not all output will be
purchased. The injection that the financial sector provides into the economy is investment (I) into
the business/firms sector. An example of a group in the finance sector includes banks such as
Westpac or financial institutions such as Suncorp.

In the government sector

The leakage that the government sector provides is through the collection of revenue through taxes
(T) that is provided by households and firms to the government. This is a leakage because it is a
leakage out of the current income, thus reducing the expenditure 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 income in the form of welfare payments, that is a form of government
spending back into the economy.

In the overseas sector

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 exporting wool to China: China pays the exporter of the wool (the
farmer), therefore, more money enters the economy, thus making it an injection. Another example is
China processing the wool into items such as coats and Australia importing the product by paying
the Chinese exporter; since the money paying for the coat leaves the economy, it is a leakage.

Summary of leakages and injections

All leakages and injections in the five-sector

model

Sector Leakages Injections

Financial Saving (S) Investment (I)

Government Taxes (T) Government spending (G)

Overseas Imports (M) Exports (X)

The state of equilibrium

In terms of the five sector circular flow of income model the state of equilibrium occurs when the
total leakages are equal to the total injections that occur in the economy. 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 a fictitious economy 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 giving 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 below 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 income, 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 causing a boom or expansion in economic
activity.

Circular flow of income effects of saving

Period Output Income Consumption Spending

1 2000 2000 2000 0

2 2000 2000 1800 200

3 1800 1800 1800 180

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 regained. An example of
this is if:

S + T + M > I + G + X the levels of income, expenditure and output will fall causing a contraction or
recession in the overall economic activity. As the income falls households will cut down on all
leakages 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 leakages increase the situation will be a higher level
of equilibrium.

Significance of study of circular flow of income

The circular flow of income is significant in four areas:[24]

1. Measurement of national income

2. Knowledge of Interdependence - Circular flow of income signifies the interdependence of each

of activity upon one another. If there is no consumption, there will be no demand and
expenditure which in fact restricts the amount of production and income.

3. Unending Nature of Economic Activities - It signifies that production, income and expenditure
are of unending nature, therefore, economic activities in an economy can never come to a halt.
National income is also bound to rise in future.

4. Injections and Leakages

Circular flow diagram as a subsystem of the environment

The economic system as a subsystem of the

environment: natural resources flow through
the economy and end up as waste and
pollution.

The circular flow diagram is an abstraction of the economy as a whole. The diagram suggests that
the economy can reproduce itself. The idea is that as households spend money of goods and
services from firms, the firms have the means to purchase labor from the households, which the
households to then purchase goods and services. Suggesting that this process can and will
continuously go on as a perpetual motion machine. However, according to the Laws of
Thermodynamics perpetual motion machines do not exist.[25] The First Laws says matter and
energy cannot be created or destroyed, and the Second Laws says that matter and energy move
from a low entropy, useful, state towards a less useful higher entropy state.[26] Thus, no system can
continue without inputs of new energy that exit as high entropy waste. Just as no animal can live on
its own waste, no economy can recycle the waste it produces without the input of new energy to
reproduce itself. The economy therefore cannot be the whole. It must be a subsystem of the larger
ecosystem.[25]

The abstraction ignores the linear throughput of matter and energy that must power the continuous
motion of money, goods and services, and factors of production. Matter and energy enter the
economy in the form of low entropy natural capital, such as solar energy, oil wells, fisheries, and
mines. These materials and energy are used by households and firms a like to create products and
wealth. After the material are used up, the energy and matter leaves the economy in the form of high
entropy waste that is no longer valuable to the economy. The natural materials that power the
motion of the circular flow of the economy come from the environment, and the waste must be
absorbed by the larger ecosystem in which the economy exists.[27]

This is not to say that the circular flow diagram isn't useful in understanding the basics of an
economy, such as leakages and injections. However, it cannot be ignored that the economy
intrinsically requires natural resources and the creation of waste that must be absorbed in some
manner. The economy can only continue churning if it has matter and energy to power it and the
ability to absorb the waste it creates. This matter and low entropy energy and the ability to absorb
waste exists in a finite amount, and thus there is a finite amount of inputs to the flow and outputs of
the flow that the environment can handle, implying there is a sustainable limit to motion, and
therefore growth, of the economy.[25]

See also

History of economic thought

Barter economy

Free-market economy

Market

Velocity of money

References

1. Gwartney, James D.; Stroup, Richard L.; Sobel, Russell S.; Macpherson, David A. (2014). Macroeconomics:
Private and Public Choice. Cengage Learning. pp. 173–175. ISBN 978-1-285-45354-5.

2. Daraban, Bogdan (2010-06-05). "Introducing the Circular Flow Diagram to Business Students". Journal of
Education for Business. 85 (5): 274–279. doi:10.1080/08832320903449527 (https://doi.org/10.1080%2F0
8832320903449527) . ISSN 0883-2323 (https://www.worldcat.org/issn/0883-2323) .
S2CID 154585027 (https://api.semanticscholar.org/CorpusID:154585027) .

3. Antoin E. Murphy. "John Law and Richard Cantillon on the circular flow of income." Journal of the History of
Economic Thought. 1.1 (1993): 47–62.

4. Backhouse, Roger E., and Yann Giraud. "Circular flow diagrams." in: Famous Figures and Diagrams in
Economics (2010): 221–230. Chapter 23.

5. Measuring the Economy : A Primer on GDP and the National Income and Product Accounts (https://bea.g
ov/NATIONAL/PDF/NIPA_PRIMER.PDF) , by Bureau of Economic Analysis (BEA), U.S. Department of
Commerce, October 2014.
 6. Cantillon 2010, p. 66

7. Aspromourgos, Tony. "'Political economy and the social division of labour: the economics of Sir William
Petty." Scottish Journal of Political Economy 33.1 (1986): 28–45.

8. Cantillon 2010, p. 69: Abstract of chapter 12.

9. In a recurrent process, the same event repeats itself on multiple occasions. In a cyclical process, a
sequence of events repeats itself on a regular basis.

10. Michel Aglietta, introduction to Aglietta, A theory of capitalist regulation. London: NLB, 1979.

11. Karl Marx, Capital, Volume II. Penguin Classics, 1992.

12. Karl Marx, Capital, Volume I. Penguin Classics, 1990, chapter 23 and Capital, Volume II. Penguin Classics,
1992, chapter 20 and 21.

13. Patinkin, Don (December 1973). "In Search of the" Wheel of Wealth": On the Origins of Frank Knight's
Circular-Flow Diagram". The American Economic Review. 63 (5): 1037–1046. JSTOR 1813935 (https://ww
w.jstor.org/stable/1813935) .

14. Frank Knight. The Economic Organization, 1933. pp.59-60

15. Knight (1933, p. 61)

16. Knight (1933, p. 60)

17. Agarwal, Vanita (2010). Macroeconomics: Theory and Policy. Pearson Education India. ISBN 978-81-317-
3149-9.

18. Dwivedi, D. N. (2010). Macroeconomics: Theory and Policy (3rd ed.). Tata McGraw-Hill Education. p. 45.
ISBN 978-0-07-009145-0.

19. Buultjens, Jeremy (2000). Excel Preliminary Economics. Pascal Press. pp. 9–10. ISBN 978-1-74020-088-2.

20. Samuelson, Paul Anthony (1948). Economics: An Introductory Analysis. McGraw-Hill Book Company.
p. 226.

21. Jackson, Dudley (1982). Introduction To Economics. Macmillan International Higher Education. ISBN 978-
1-349-16933-7.

22. Beveridge, Thomas (2013-03-29). A Primer on Macroeconomics. Business Expert Press. ISBN 978-1-
60649-424-0.

23. Bouman, John. Principles of Macroeconomics.

24. Perkins, J. O. N. (1990-06-18). A General Approach to Macroeconomic Policy. Springer. ISBN 978-1-349-
10661-5.

25. Daly, Herman E., and Joshua C. Farley. Ecological Economics: Principles and Applications. Washington:
Island, 2011. Print. p. 29.
 26. Drake, Gordon W.F. "Thermodynamics." Encyclopædia Britannica. Encyclopædia Britannica, Inc., 3 April
2017. Web. 4 April 2017.

27. Daly, Herman E., and Joshua C. Farley. Ecological Economics: Principles and Applications. Washington:
Island, 2011. Print. p. 29–34.

Attribution

This article incorporates text from Bureau of Economic Analysis. Measuring the Economy : A Primer
on GDP and the National Income and Product Accounts (https://bea.gov/NATIONAL/PDF/NIPA_PRIME
R.PDF) , 2014, a publication now in the public domain.

Further reading

Backhouse, Roger E., and Yann Giraud. "Circular flow diagrams." in: Famous Figures and Diagrams
in Economics (2010): 221–230. Chapter 23.

Richard Cantillon, Chantal Saucier (translation) & Mark Thornton (editor) (2010) [1755]. An Essay
on Economic Theory (http://mises.org/books/Essay_on_economic_theory_cantillon.pdf) . Auburn,
Alabama: Ludwig von Mises Institute. ISBN 0-415-07577-7.

Daraban, Bogdan. "Introducing the Circular Flow Diagram to Business Students." Journal of
Education for Business 85.5 (2010): 274–279.

Mankiw, Gregory (2011). Principles of Economics, 6th edition. Thomson Europe.

Marks, Melanie, and Gemma Kotula. "Using the circular flow of income model to teach economics
in the middle school classroom." The Social Studies 100.5 (2009): 233–242.

Lloyd A. Metzler. “Three Lags in the Circular Flow of Income”, in: Income, Employment and Public;
essays in honor of Alvin H. Hansen, Lloyd A Metzler; New York, W.W. Norton [1948]. pp. 11–32

Antoin E. Murphy. "John Law and Richard Cantillon on the circular flow of income." Journal of the
History of Economic Thought. 1.1 (1993): 47–62.

Sloman, John (1999). Economics, 3rd edition (https://archive.org/details/economics0000slom) .

Prentice Economics. Europe: Prentice-Hall. ISBN 0-273-65574-4.

External links

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