The Circular Flow of Income and Expenditure

And, both sectors set aside a portion of their income to pay taxes to the government. Businesses use the money to buy inputs in factor markets.

What are the 4 main parts of a circular flow diagram?

The four main parts of the circular flow diagram are individuals, firms, market for goods and services, and market for factors of production. These four parts serve as a framework for understanding the continuous flow of money throughout an economy.

The government can choose to raise taxes or limit government spending. The money flows back to households when foreign countries give them employment. For firms, money flows back when foreign countries purchase goods and services, also called exports. A government calculates its gross national income by tracking all of these injections into the circular flow of income and the withdrawals from it. Some of the goods produced in an economy are not consumed by domestic households or firms in an economy but are instead exported to other countries. Whenever one country sells something to another country, it acquires an asset from that country in exchange. For example, suppose a US movie company sells DVDs to an Australian distributor.

Circular Flow of Income

Thus, the five-sector model includes households, firms, government, the rest of the world, and the financial sector. The financial sector includes banks and non-bank intermediaries that engage in borrowing and lending . Residuals from each market enter the capital market as savings, which in turn are invested in firms and the government sector.

  • Hence, the flow of money follows from the firms and households to the government in taxes.
  • This chapter discusses François Quesnay’s contributions to macroeconomics.
  • In this way, the circular flows of income and expenditure remain in equilibrium.
  • Importsrepresent the purchase of goods and services from the external sector by the domestic economy.
  • Therefore, firms offer us incomes which we send back to firms in the form of spending.

The equation shows the equilibrium condition in the circular flow of income and expenditure. Like the business sector, modern governments also export and import goods and services, and lend to and borrow from foreign countries.

Types of Circular Flow of Income

There are a number of different types of circular flow models within the field of economics. Some models, such as the two sector model in Figure 1, depict the market from a microeconomic perspective and primarily focus on the individual relationships between consumers and producers. There are also alternative models of the circular flow diagram such as the money flow model and the real flow model. The money flow model illustrates the exchange of money in regards to the value of goods and services. The real flow model on the other hand depicts the exchange of the goods and services themselves in the economy. It shows the regular flow of products, factors, and money received and paid among the household, business, government, and foreign sectors through the product, resource/factor, and financial markets. Figure 3 shows that taxes flow out of the household and business sectors and go 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 that provides collective services and welfare payments to the community. Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. The household sector buys goods imported from abroad and makes payment for them which is a leakage from the circular flow. The households may receive transfer payments from the foreign sector for the services rendered by them in foreign countries. Now we take the household, business and government sectors together to show their inflows and outflows in the circular flow. As already noted, taxation is a leakage from the circular flow.

Lesson summary: The circular flow and GDP

But, if the leakage is higher than the injection, the national income will decrease. Government spending– the government injects money into the circle through programs such as transfer payments to the household sector and subsidies to the business sector.

The Circular Flow of Income and Expenditure

These five avenues consist of individuals, businesses, governments, financial institutions, and foreign governments/economies/markets. This model incorporates a modern depiction of the economy due to the expansion of globalization and international trade. The government offsets these leakages by making purchases from the business sector and buying services of the household sector equal to the amount of taxes.

Circular Flow in a Two Sector Economy:

When you pay your check, you are buying goods and services. But the money doesn’t remain in the cash register for long. Learn more about the Econ Lowdown Teacher Portal and watch a tutorial on how to use our online learning resources. These borrowings take place as the sale of government bonds and other securities to the public or financial intermediaries. Individuals spend all their income on goods and services without the intention to save part of their income. Every transaction that affects expenditure must affect income, and every transaction that affects income must affect expenditure.

  • The flow of money is shown with purple, and the flow of goods and services is shown with orange.
  • If saving increases, this depresses the circular flow of income.
  • The amount of investment actually undertaken during a year; equals planned investment plus unplanned changes in inventories.
  • They also invest their capital in foreign countries and receive profit income.
  • Macroeconomics studies an overall economy or market system, its behavior, the factors that drive it, and how to improve its performance.

As shown above, leakages are if exactly equal to injections the circular flow of an economy will be in a balanced state. If injections exceed leakages, the national income of the country will be increased. On the other side, if leakages exceed the injections, the country’s national income will be declined. The government payments like social security payments, pensions, allowances, retirement benefits, and temporary aid to needy families, etc. are examples of transfer payments. Leakages and Injections play a vital role in the operation of the circulation flow model. The presence of leakages and injections in the circular flow model makes it inconsistent.

Significance of study of circular flow of income

Households sell land, labor, capital, and entrepreneurial activity in exchange for money, which in this case is called income. Households consist of one or more persons who live in the same housing unit, such as a family. Households own all the economic resources in the economy. The economic resources are land, labor, capital, and entrepreneurial ability. They make payments for the imports which they received from the foreign sector.

The new milkshake machine and french fry cutter—capital resources—were bought from a business three states over and the stockholders of that business are members of households. Finally, The Circular Flow of Income and Expenditure the diner itself is owned by Alice, who is a member of a household and an entrepreneur who has turned her skill of making the best homemade fries in town into a successful business.

In today’s increasingly globalized world households particularly supply labor services to foreign countries also and they receive remittance income. They also invest their capital in foreign countries and receive profit income. The economics model can be shown in terms of producers and consumers. So, what are producers and consumers in terms of the circular flow of income and expenses? This video will answer that question by providing you with examples of the circular flow of income and expenses. Households both receive money and spend money in the circular flow diagram. Businesses exchange the revenue earned in the market for goods and services to buy land, labor and capital in the market for resources.

In the three-sector model, the government is added to the two-sector model. In this model, money flows from households and businesses to the government in the form of taxes. The government pays back in the form of government expenditures through subsidies, benefit programs, public services, etc. This is the most basic circular flow model of an economy. In reality, there are more parties participating in a more complex structure of circular flows.

  • You report back to the International Monetary Fund team that production has been declining in recent years.
  • Luckily, economists have developed models to help us learn and understand how the economy functions.
  • They can also include natural causes such as environmental disasters which can cause unexpected supply shortages and lost revenue.
  • Household and business sectors pay taxes to the government.
  • Businesses use the economic resources they buy in the market for resources to produce goods, such as computers and bicycles, and services, such as haircuts and car repairs.
  • M represent import of goods and services produced by others country.

If spending equals income for each individual household, then spending also equals income for the household sector as a whole. As this is true for each individual firm, it is also true for the sector as a whole. The circular flow reveals that there are several different ways to measure the level of economic activity. From the household perspective, we can look at either the amount of income earned by households or their level of spending.


The national product is the value of final goods and services produced in a country. Since all the value produced must belong to someone in the form of a claim on the value, national product is equal to national income. Each transaction in an economy involves a buyer and a seller. Households spend money for buying goods and services produced. The circular flow also illustrates the equality between the income earned from production and the value of goods and services produced. 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 .

The Circular Flow of Income and Expenditure

Those may be treated in the same way that saving and investment were treated—as leakages or injections. Thus, exports constitute spending by foreign nationals on domestic goods—an injection. Imports constitute spending out of domestic income on foreign goods—a leakage. The households then spend money on the goods and services produced by firms. This money is then used by firms to pay the households for their work, through wages. (This is represented by the green, outer loop in the diagram below.) This process repeats itself and forms the circular flow of income. – Any payment of income other than by firms or any spending other than by domestic households; includes investment, government purchases, transfer payments, and exports.

It tends to reduce consumption and saving of the household sector. Reduced consumption, in turn, reduces the sales and incomes of the firms. On the other hand, taxes on business firms tend to reduce their investment and production.

The Circular Flow of Income and Expenditure

It shows the flow of money, goods and services, and factors of production through the economy.” – Paul Krugman. Explain the role of households in the circular flow diagram. Be specific about the flow of money that they receive and pay in addition to what they give and receive from firms. Let’s take a look at the role of the consumer, or the households. In a circular flow diagram, households consume the goods offered by the firms. However, households also offer firms factors so that the firms can produce products for the household to later consume.

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. 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. François Quesnay further developed these concepts, and was the first to visualize these interactions over time in the so-called Tableau économique. Where Y represents the production of goods and services, C for consumption expenditure, I investment level in the economy and G for government expenditure respectively. If exports exceed imports, the economy has a surplus in the balance of payments. And if imports exceed exports, it has a deficit in the balance of payments.

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