18 4: The Circular Flow of Income

We now include the government into our simplified model of the economy. 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. An economy can achieve Equilibrium when the Leakages of an economy are equal to the Injections. Steve has taught A Level, GCSE, IGCSE Business and Economics – as well as IBDP Economics and Business Management.

As long as a country’s injections is greater than its leakages, a country’s economy can theoretically remain sustaining forever. However, if there are cash flow shortages (i.e. leakages), the country must find additional cash flow to compensate for the shortage. That is the basic form of the model, but actual money flows are more complicated. Economists have added in more factors to better depict complex modern economies. These factors are the components of a nation’s gross domestic product (GDP) or national income.

In terms of the Five Sector Model, we have injections (money flowing into the economy) and leakages (where money leaves the economy). The behavior of firms and individuals inside of markets is the focus of microeconomics. Learn how prices are set, the motivations of buyers and sellers interact, and the ways in which markets are structured here. Of course, international transactions in practice are more complicated than these simple examples. Yet the insight we have just uncovered remains true no matter how intricate the underlying financial transactions are. Looking at some basic measurements of the economy has allowed you to be more concrete about the problems in Argentina.

The Global Economy

As long as lending (injection) is equal to borrowing (leakage), the circular flow reaches an equilibrium and can continue forever. In the circular flow of an economy in a two-sector model without the financial market, it is assumed that no savings are made in the economy. It means that the households spend their entire income on the purchase of goods and services and every firm spends all the receipts from the sale of goods and services to make factor payments. The inflows of money in the financial market in a four-sector economy are equal to the outflows of money, which makes the circular flow of income continuous and complete. There are many different ways of saving, but we do not focus on these differences.

Injections in Different Types of Economies

1. When we talk about the five sector model, we discuss money flowing into the economy (injections) and money leaving the economy (leakages).
2. Just as money is injected into the economy, money is withdrawn or leaked through various means as well.
3. Exports are the goods sold by firms to foreign countries, resulting in an inflow of income into the economy.
4. From the household perspective, we can look at either the amount of income earned by households or their level of spending.
5. When the value of injections EXCEEDS the value of leakages, the economy is growing.

Those income flows are added to the trade surplus/deficit to give the current account of the economy. It is the current account that must be matched by borrowing from or lending to other countries. A positive current account means that net exports plus net income flows from the rest of the world are positive. In this case, our economy is lending to the rest of the world and acquiring more assets. Governments collect taxes from households (so, households pay tax to the government). The government then spends money in the economy in many ways, including unemployment benefits and infrastructure spending.

What Are the Limitations of a Circular Flow Model?

You report back to the International Monetary Fund (IMF) team that production has been declining in recent years. You also report that there was a recent explain circular flow of national income with five sector model increase in the price level. As yet, though, you do not know anything about either the causes or the consequences of these events.

The flows in and out of the firm sector of an economy must balance. The total flow of dollars from the firm sector measures the total value of production in the economy. The total flow of dollars into the firm sector equals total expenditures on GDP, which we divide up into four categories.

Government borrowing is sometimes referred to as the government budget deficit. A common, though not official, definition of a recession is two consecutive quarters of declining GDP. When this happens, governments and central banks adjust fiscal and monetary policy to boost growth.

1. The idea of circular flow was first introduced by economist Richard Cantillon in the 18th century and then progressively developed by Quesnay, Marx, Keynes, and many other economists.
2. The government then spends money in the economy in many ways, including unemployment benefits and infrastructure spending.
3. However, the firm sector produces goods and services and sells them to households.
4. We need frameworks to help us make sense of the data that we gather.
5. We can use the terms income, spending, production, and GDP completely interchangeably.
6. First, households may spend money and in return, the households get new innovative technology products.

The Causes of a Decrease in Real GDP

This flow of goods and services and factors payments between firms and households reflects the circular flow of money in an economy. The financial sector of an economy is at the heart of the circular flow. It summarizes the behavior of banks and other financial institutions. Most importantly, this sector of the circular flow shows us that the savings of households provide the source of investment funds for firms. On the left-hand side, the figure shows a flow of dollars from the household sector into financial markets, representing the saving of households. On the right-hand side, there is a flow of money from the financial sector into the firm sector, representing the funds that are available to firms for investment purposes.

First, households may spend money and in return, the households get new innovative technology products. Households may contribute labor hours and time to the company resulting in Apple growing and becoming a more successful company. Households receive income from Apple, though part of these funds is given to the government via taxes.

Each sector within a circular flow model may be designated with a capital letter often used to describe how to calculate GDP. How an economy runs can be simplified as two cycles flowing in opposite directions. One is goods and services flowing from businesses to individuals, and individuals provide resources for production (labor force) back to the businesses. Exports are the goods sold by firms to foreign countries, resulting in an inflow of income into the economy. Imports are the goods purchased by the residents of a country from foreign countries, resulting in an outflow of income from the economy. From the government’s perspective, both households and business pay taxes.

A change in one sector may critically change the rest of the circular flow model. This change would likely have major repercussions on business, individuals, and other sectors within the circular flow model. The circular flow model is aptly named because funds tend to continuously flow between sectors. As highlighted in the diagram below, money often flows from one sector to another, awarding benefits along the way. No single sector should hoard or collect all resources; instead, a fully-functioning circular model will continuously move funds so each sector can operate appropriately. Note that this example below is a single type of model and does not represent all circular flow models.