The Circular Flow of Income

The Circular Flow of Income

This topic is called 'Aggregate demand and supply. But before we look at these concepts, it is important that you understand the 'big picture'. The circular flow of income is a good place to start. It shows all of the money coming into an economy (injections) and all of the money that goes out of an economy (leakages or withdrawals). It allows you to see the 'general' reasons why an economy might grow or shrink in size. Once you can see the 'big picture' we can then look at the specifics of aggregate demand and aggregate supply.

Let's start with the simplest model. The economy is assumed to consist of only two sectors: households and firms.

The Circular Flow of Income

In this very simple model of the whole economy, it is assumed that the households own all the factors of production. They sell these factors to the firms, earning rent on their land, wages for the use of their labour, and profit and interest for the use of their capital. This is shown on the left hand side of the diagram. The green line shows the factors of production going from the households to the firms and the red line shows the money payments by the firms for these factors going back to the households.

The firms then use these factors to produce goods and services. And who buys these goods and services? The households, of course, using the income they earned from the sale of their factors. This is shown on the right hand side of the diagram. Again, the green line represents movements of the physical and the red line shows the movement of the money.

Although this model is very simple, it does emphasise one very important point. When measuring the size of an economy, or the level of economic activity, there are three ways of doing it. In the diagram above you can see that three of the four moving lines have also been labelled in black. The 'rent, wages, profit and income' branch represents total income of the economy. The 'goods and services' branch represents the total output of the economy and the 'expenditure on goods and services' branch represents the total expenditure of the economy.

So the size of an economy can be measured using either the income, output or expenditure method. Notice that the three methods should give exactly the same answer. It is fairly obvious that the amount of money spent must equal the value of the goods and services that this money is spent on. Although less obvious, it should make sense that the amount of money spent will equal the income of the spenders, assuming that none of this income is saved. This brings us to another key point. There are no injections into this circularflow and no leakages from the circular flow (like saving) at this stage. Hence, Income = Output = Expenditure.

Including leakages and injections

In this simple model, we have, so far, assumed that the system is completely closed. It would be fair to assume, though, that households will not spend all of their income, and that firms will, on occasion, invest in new capital.

The Circular Flow of Income

The diagram above has taken the first circular flow diagram a step further.The two blue lines show savings leaking out of the economy and the injection of investment into the economy. Where does the saving leakage go, and where does the investment injection come from? Put very simply, savings are deposited in the banking sector or the capital markets, and the firms borrow to invest from the same sort of sources.

In the first diagram, E (Expenditure) = O (Output) = Y (Income). Now there are two types of expenditure: consumption (by households) and investment (by firms), So E = C + I. Also, the households? income is not all spent anymore. Some of it is saved, so Y = C + S. We know that in equilibrium, Y = E, so by substituting we have:

Y = E
C + S = C + I
S = I (by cancelling out the Cs)

So we can see that in this 2-sector model, actual investment (the injection) must equal actual saving (the leakage). It makes sense that the injections should equal withdrawals in equilibrium. Think of the circular flow diagram as water flowing through pipes, and the 'households' and 'firms' squares as water tanks. If injections were greater than withdrawals, the amount of water in the system would become infinite, which doesn't make sense. If withdrawals were greater than injections, after a time there would be no water in the system, which also doesn't make sense.

Although the amount that households plan to save may not be the same as the amount that firms plan to invest, the actual amounts are always equal. If the plans are not the same, the firms' stock levels (which count as investment) will adjust until actual investment (planned investment plus unplanned changes in the stock level) equals actual saving. Of course, the economy is only in an equilibrium position if the plans are the same. Otherwise, firms will find their stocks build up (or disappear) and change their output levels accordingly to allow for the different saving plans (and, therefore, consumption plans) of the households.

It does make sense that savings equals investment. In most economies in the world, the amount that is invested over the long term is closely related tothe amount that the economy saves. The UK traditionally has quite a low savings ratio, especially when the economy is doing well, and this has been translated into a poor record on investment over the years. In Japan, the savings ration is very large. Investment is also high in Japan, as is their investment in projects abroad.

In the real world, we know that there are more 'players' in an economy than simply households and firms. The '3-sector' model includes the government sector. For the purposes of the circular flow diagram, governments do two things: they tax businesses and consumers, and they then spend this money on consumers (benefits and pensions) and businesses (subsidies). The diagram below includes the government sector.

The Circular Flow of Income

We now have the following situation: E = C + I + G, Y = C + S + T and Y = E in equilibrium, so:

Y = E
C + S + T = C + I + G
S + T = I + G (by cancelling the Cs)

The situation is a little more complicated now. We have two leakages (saving and taxation) and two injections (investment and government spending). Now that we have a situation where actual saving does not necessarily have to equal actual investment. Now, saving and taxation together have to equal investment and government spending together. This means that investment can be greater than saving as long as taxation is higher than government spending (and vice versa).

We are still missing something. We have not yet included the foreign sector, or exports and imports. Notice that in the diagram below, X denotes exports and M denotes imports. Don't ask why, that's just the way it is!

The Circular Flow of Income

The foreign sector box has been added on the right of the diagram. The black line for imports (M) comes out of the red consumption (C) line. This is because it is the consumers who buy these imports (like German and Japanese cars) which means that money leaks out of the economy. The injection into the economy is the exports (X). This black line rejoins the red consumption line because exports are consumption by foreigners of UK goods and services.

So, now our equilibrium formula will look like this:

Y = E
C + S + T + M = C + I + G + X
S + T + M = I + G + X (by cancelling out the Cs)

S, T and M are the leakages from an economy and I, G and X are the injections into an economy. The economy will only be in equilibrium if injections equal leakages.

You may have seen in many textbooks the fact that National expenditure, or aggregate planned expenditure, is equal to C + I + G + X − M. The reason why M is included, but not S or T is that imports are a sub-group of consumption (or C). C includes all consumption by UK consumers, including the consumption of imports as well as home produced goods. This has to be taken away because it is a leakage. S and T are also leakages, but are not contained within C, I, G or X. They are separate and not part of expenditure, so they are not included.