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THE CIRCULAR FLOW OF INCOME

The movement of spending and

income throughout the economy
 Learning Objectives

After The Topic Is Over, You Can

• Explain the Circular Flow of Income.

• Recall how leakages and injections affect the

circular flow.

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 The Circular Flow Of Income

Households

Spending

Factor Incomes Products Factor Services

Firms

Factor Incomes Factor Services

Wages/Salaries Labour
Interest Capital
Profit Entrepreneur 4
Rent Land
 But there are complications….
• Not all FACTOR INCOME is spent on goods.

There are leakages from income. What do you think

these are?:
• Taxation - taken from wages and off the price of
goods (VAT) etc
• Savings – households may not spend all their
income
• Imports – households and firms may spend on
imports.

ALL OF THE ABOVE ARE LEAKAGES FROM INCOME

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 The Circular Flow Of Income

Tax
Savings
Imports

Households

Spending

Factor Incomes Products Factor Services

Firms

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These LEAKAGES reduce the circular flow of income WHY ?

They represent money leaving Income :

 Taxation goes to government.
 Savings are put into bank accounts.
 Import spending goes abroad.

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 INJECTIONS
In contrast, there are 3 forms of spending that are injected into
the flow.
Injection: Additions of extra spending into the circular flow of
income
These are ;
• Government Spending
• Investment
• Exports
What are each of the above?
• Government spending is money spent by the government on
NHS, defence, benefits, education etc.
• Investment is money spent by firms on capital goods.

• Exports are goods sold by firms abroad

Injections come from outside of the circular flow.

They increase the circular flow. 8
 The Circular Flow Of Income
Savings
Imports
Tax

Households

Spending

Factor Incomes Products Factor Services

Firms
Investment
Exports
Government
Spending 9
WHAT DO INJECTIONS AND LEAKAGES DO TO THE CIRCULAR
FLOW OF INCOME?

If Injections > Leakages then…. ?

Income Rises

If Leakages > Injections then…. ?

Income Falls

If Injections = Leakages then…. ?

Income Stays the Same

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 RECAP
1. What is the circular flow of income?

2. What is an injection?

3. What is a leakage?

4. What are the 3 leakages and 3 injections?

5. Draw it.
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 Circular Income Flow in a Two Sector Economy:

Real flows of resources, goods and services have been

shown in Figure.
In the upper loop of this figure, the resources such as
land, capital and entrepreneurial ability flow from
households to business firms as indicated by the
arrow mark.
In opposite direction to this, money flows from
business firms to the households as factor payments
such as wages, rent, interest and profits.

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 Circular Income Flow in a Three Sector Economy:

In our above analysis of money flow, we have ignored

the existence of government for the sake of making
our circular flow model simple.

This is quite unrealistic because government absorbs a

good part of the incomes earned by households.
Government affects the economy in a number of
ways.

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 Circular Income Flow in a Three Sector Economy:

Here we will concentrate on its taxing, spending and borrowing roles.

Government purchases goods and services just as households and
firms do. Government expenditure takes many forms including
spending on capital goods and infrastructure (highways, power,
communication), on defence goods, and on education and public
health and so on.

These add to the money flows which are shown in Figure, where a box
representing Government has been drawn. It will be seen that
government purchases of goods and services from firms and
households are shown as flow of money spending on goods and
services.

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Money Income Flows in the Four Sector Open Economy: Adding
Foreign Sector:

We now turn to explain the money flows that are generated in

an open economy, that is, economy which have trade
relations with foreign countries. Thus, the inclusion of the
foreign sector will reveal to us the interaction of the domestic
economy with foreign countries.
Foreigners interact with the domestic firms and households
through exports and imports of goods and services as well as
through borrowing and lending operations through financial
market. Goods and services produced within the domestic
territory which are sold to the foreigners are called exports.

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Money Income Flows in the Four Sector Open Economy:
Adding Foreign Sector:

On the other hand, purchases of foreign-made goods and

services by domestic households are called imports.
Figure illustrates additional money flows that occur in
the open economy when exports and imports also
exist in the economy.

In our analysis, we assume it is only the business firms of

the domestic economy that interact with foreign
countries and therefore export and import goods and
services.
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