Circular flow of income

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In this simplified image, the relationship between the decision-makers in the circular flow model is shown. Larger arrows show a primary factors, whilst the red smaller arrows show subsequent or secondary factors.

In economics, the term circular flow of income or circular flow refers to a simple economic model which describes the reciprocal circulation of income between producers and consumers.^[1][2] In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income^[1]. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households.

The circle of money flowing through the economy is as follows: total income is spent (with the exception of "leakages" such as consumer saving), while that expenditure allows the sale of goods and services, which in turn allows the payment of income (such as wages and salaries). Expenditure based on borrowings and existing wealth – i.e., "injections" such as fixed investment – can add to total spending.

In equilibrium (Preston), leakages equal injections and the circular flow stays the same size. If injections exceed leakages, the circular flow grows (i.e., there is economic prosperity), while if they are less than leakages, the circular flow shrinks (i.e., there is a recession).

More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports.

Labor and other "factors of production" are sold on resource markets. These resources, purchased by firms, are then used to produce goods and services. The latter are sold on product markets, ending up in the hands of the households, helping them to supply resources.

[edit] Assumptions

The basic circular flow of income model consists of six assumptions:

1. The economy consists of two sectors: households and firms.
2. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).
3. All output (O) produced by firms is purchased by households through their expenditure (E).
4. There is no financial sector.
5. There is no government sector.
6. There is no overseas sector.

[edit] Two Sector Model

In the simple two sector circular flow of income model the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is:

Y = E = O

This means that the expenditure of buyers (households) becomes income for sellers (firms). The firms then spend this income on factors of production such as labour, capital and raw materials, "transferring" their income to the factor owners. The factor owners spend this income on goods which leads to a circular flow of income.

[edit] Five sector model

Table 1 All leakages and injections in five sector model

LEAKAGES       INJECTION
Saving (S)     Investment (I)
Taxes (T)      Government Spending (G)
Imports (M)    Exports (X)

Circular flow of income diagram

The five sector model of the circular flow of income is a more realistic representation of the economy. Unlike the two sector model where there are six assumptions the five sector circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three more sectors introduced. The first is the Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing (savings from households) and lending of money. 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 can not 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.

The next sector introduced into the circular flow of income is the Government Sector that consists of the economic activities of local, state and federal governments. 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. For this reason they are 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.

The final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to an open economy. 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.

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:

This can be further illustrated through the fictitious economy of Noka where:

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:

Therefore it can be shown as one of the below equations where:

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.

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 (Figure 4) 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 they will continue to rise until they are equal to the level injections. The end result of this disequilibrium situation will be a higher level of equilibrium.

[edit] See also

• History of economic thought
• Barter economy
• Demand economy
• Free-market economy
• Market

[edit] References

1. Sloman, John (1999). Economics, 3^rd edition, Prentice Economics. Europe: Prentice-Hall. ISBN 0273655744. 
2. Mankiw, Gregory (2006). Principles of Economics. Thomson Europe. ISBN 1844801330. 

[edit] Notes