The circular flow of income model

• The model in a closed economy with no government

• LESSON OBJECTIVES
• Describe, using a diagram, the circular flow of income
between households and firms in a closed economy with
no government.
• Identify the four factors of production and their
respective payments (rent, wages, interest and profit) and
explain that these constitute the income flow in the
model.
• Outline that the income flow is numerically equivalent to
the expenditure flow and the value of output flow
Circular flow of income model in a closed economy
with no government
 Circular flow of income model in a closed economy
with no government- An explanation

• The circular flow of income model illustrates a number of

concepts and relationships that will help us understand the
macroeconomy. In its simplest version, shown in Figure 1
above, the model illustrates a closed economy, meaning it
has no links with other countries (it is ‘closed’ to
international trade), and is also a model of an economy with
no government.
• It is assumed that the only decision-makers are households
(or consumers) and firms (or businesses); both are shown in
square boxes. Households and firms are linked together
through two markets: product markets and resource
markets, shown in diamonds.
The clockwise direction of the Circular flow of income

• Households are owners of the four factors of

production: land, labour, capital and
entrepreneurship. Firms buy the factors of
production in resource markets and use them to
produce goods and services. They then sell the
goods and services to consumers in product
markets. We therefore see a flow in the clockwise
direction of factors of production from
households to firms, and of goods and services
from firms to households.
 The anti-clockwise direction of the Circular flow of
income

• In the counterclockwise direction, there is a flow of money

used as payment in sales and purchases.
• When households sell their factors of production to firms,
they receive payments taking the form of rent (for land),
wages (for labour), interest (for capital) and profit (for
entrepreneurship). These payments are the income of
households.
• The payments that households make to buy goods and
services are household expenditures (or consumer spending).
The payments that firms make to buy factors of production
represent their costs of production, and the payments they
receive by selling goods and services are their revenues.
 SPENDING BY HOUSEHOLD EQUALS THE VALUE OF
FIRM’S OUTPUT
• This model demonstrates an important principle: the income flow
from firms to households is equal to the expenditure flow from
households to firms. In other words, the household incomes coming
from the sale of all the factors of production equals the expenditures
by households on goods and services. This is the circular flow of
income.
• In addition, these two flows must be equal to the value of goods and
services, or the value of total output produced by the firms, known as
the value of output flow. The reasoning of this is as follows: if each
good and service is multiplied by its respective price, we obtain the
value of each good and service, and adding them all up we arrive at
the value of total output. This value is the same as consumer
expenditure, since spending by consumers is equal to each item they
buy multiplied by its price.
 IN SUMMARY
• Therefore: The circular flow of income shows
that in any given time period (say a year), the
value of output produced in an economy is
equal to the total income generated in
producing that output, which is equal to the
expenditures made to purchase that output.
The Circular flow of income model in an
open economy
 Adding leakages and injections
• Learning objective:
• Describe, using a diagram, the circular flow of
income in an open economy with government
and financial markets, referring to
leakages/withdrawals (saving, taxes and
import expenditure) and injections
(investment, government expenditure and
export revenue).
 Adding leakages and injections
• The real-world economy is more complicated than
this simple model suggests. We arrive at a closer
picture of the real world by adding injections and
leakages (also known as withdrawals) to the money
flow of the Figure1. To understand what these are,
consider a pipe with water flowing through it, as in
Figure 2a. As water flows through the pipe, some
leaks out (the leakages), while new supplies of
water are injected in (the injections). It is the same
with the flows of money in the circular flow model.
leakages and injections
The Circular flow of income model in an open economy with
international trading and government participation
 Saving and investment – Household does the savings

• Saving is the part of consumer income that is not spent but

is saved. Investment is spending by firms for the production
of capital goods, which is one of the four factors of
production (physical capital. This is why capital goods are
also known as 4 goods. How are saving and investment
linked together as leakages and injections? When
households save part of their income, this represents a
leakage from the circular flow of income because it is
income that is not spent to buy goods and services.
Households place their savings in financial markets (bank
accounts, purchases of stocks and bonds, etc.).
Saving and investment – The firm does the
investment
• Firms obtain funds from financial markets (through
borrowing, issuing stocks and bonds, etc.) to finance
investment, or the production of capital goods. These funds
therefore flow back into the expenditure flow as injections.
This process is shown in Figure 2b, which, in addition to the
money flows of Figure 1, shows the three leakage/injection
pairs above. (For simplicity, this figure contains only money
flows.) Leakages appear in the left-hand side of the figure,
and injections on the right. We can see that saving leaks out
of the flow of consumer expenditures, and after passing
through financial markets is injected back into the
expenditure flow as investment.
 Taxes and government spending

• Taxes and government spending are connected

to each other through the government.
Households pay taxes to the government; this
is a leakage because it is income that is not
spent to buy goods and services. The
government uses the tax funds to finance
government expenditures (on education,
health, defence, etc.) and this spending is an
injection back into the expenditure flow.
 Imports and exports

• Imports are goods and services produced in other countries

and purchased by domestic buyers. Exports are goods and
services produced domestically and purchased by
foreigners. When an economy has international trade
through imports and exports, it is known as an open
economy. Imports and exports are linked together through
‘other countries’. Imports are a leakage because they
represent household spending that leaks out as payments
to the other countries that produced the goods and
services. Exports are an injection because they are spending
by foreigners who buy goods and services produced by the
domestic firms.