What is the Circular Flow of Income? (Cambridge (CIE) A Level Economics): Revision Note

The closed circular flow of income model

• The circular flow of income model is used to illustrate national income and the flow of money, resources and goods in an economy

  • There is a simple model which shows the money flows in a 'closed economy'

    • This shows money flows between households and firms 

  • There is a more complex model which adds in other economic agents, including the government, financial sector and foreign trade (net exports)

Circular flow in a closed economy

Diagram analysis

• Households own the wealth in the economy

  • These are the factors of production

• Households supply their factors of production to firms and receive income as a reward

  • They receive rent for land, wages for labour, interest for capital, and profit for enterprise

  • With this income, they purchase goods and services from firms

• Firms purchase factors of production from households

  • They use these resources to produce goods and services

  • They sell the goods and services to households and receive sales revenue

The open circular flow of income model

• An open circular flow of income demonstrates the relationship between all of the economic agents that interact in a global world

• There are high levels of interdependence between households, firms, the government, the financial sector, and the foreign sector (foreign firms and households)

Diagram: Circular flow in an open Economy

Diagram analysis

• Households and firms have been explained in the closed circular flow of income model above

• Government: The government influences the size of the circular flow through its taxation (T) and spending policies (G)

• Financial sector: The financial sector influences the size of the circular flow by providing funds for Investment (I) and a safe place for households and firms to store their savings (S)

• Foreign sector: Globalisation means that the level of exports (X) and imports (M) significantly affects the size of the circular flow of income in most countries

Injections and leakages

• Money can enter or leave the circular flow of income in an economy

  • Injections represent new income in the economy

  • Withdrawals are the leakage of money from the economy

• Injections add money to the circular flow of income and increase its size

  • Increased government spending (G)

  • Increased investment (I)

  • Increased exports (X) 

• Leakages (withdrawals) remove money from the circular flow of income and reduce its size

  • Increased savings by households (S)

  • Increased taxation by the government (T)

  • Increased import purchases (M) 

• There are high levels of interdependence between households, firms, the government, the financial sector, and the foreign sector (foreign firms and households)

Circular flow with Injections and leakages  

Diagram analysis

• Government: Government spending (G) is an injection and taxation (T) is a leakage

• Financial sector: Investment (I) is an injection and savings (S) is a leakage

• Foreign sector: Exports (X) is an injection and imports (M) is a leakage

• The relative size of the injections and withdrawals impacts the size of the economy

  • Injections > withdrawals = economic growth and increase in national income

  • Withdrawals > injections = economic decline and a fall in national income 

• Changes to any of the factors that influence government spending, investment, consumption and net exports will increase or decrease the relative size of the circular flow of income

  • E.g. An increase in interest rates will increase savings (withdrawal) and reduce consumption and investment

Identifying injections and leakages from transaction descriptions

• In the exam, injections and leakages are not always labelled as G, I or X - instead they appear as specific financial transactions that must be classified correctly

• The test to apply is: does this flow add money into the domestic circular flow from outside, or does it remove money from it?

  • If money enters the domestic circular flow from outside the household-firm loop → injection

  • If money leaves the domestic circular flow → leakage

• Common transactions that are injections:

  • Government spending on goods, services or interest payments on bonds - all represent money flowing from government into the circular flow

  • Bank lending to firms for investment - money flows from the financial sector into the circular flow

  • Export revenues - money flows into the domestic economy from abroad

• Common transactions that are leakages:

  • Taxation of households or firms - money flows out to government

  • Household saving or firm repayment of bank loans - money flows out to the financial sector

  • Dividends or profits paid to foreign shareholders - money flows out of the domestic economy abroad

  • Import expenditure - money flows out to foreign producers

• The direction trap: always check which way the flow moves

  • Dividends received from abroad → injection

  • Dividends paid to foreign shareholders → leakage

  • The same transaction type can be either, depending on direction

Equilibrium and disequilibrium in the circular flow

1. Equilibrium national income

• Equilibrium national income occurs when total injections equal total withdrawals - the size of the circular flow is stable and national income is neither rising nor falling

Injections (I + G + X) = Withdrawals (S + T + M)

• At this point, the plans of all economic agents are consistent

  • Households, firms, government and the foreign sector are all satisfied with current income and spending levels

• Equilibrium does not require each individual injection to equal its corresponding leakage

  • Investment does not need to equal savings, nor exports equal imports - only the totals must balance

2. Disequilibrium national income

• Disequilibrium occurs when total injections do not equal total withdrawals

  • The circular flow is either expanding or contracting

• There are two possible states of disequilibrium:

• These changes are self-reinforcing in the short run

  • When injections exceed withdrawals, firms receive more revenue, hire more workers, pay more factor incomes, and households spend more - amplifying the initial change in income

Moving towards a new equilibrium

• Following a disequilibrium, national income adjusts until injections and withdrawals are equal again at a new equilibrium level

  • If government spending rises, national income expands until the additional income generated causes withdrawals (saving, tax, imports) to rise sufficiently to match the new higher level of injections

  • If households save more, national income contracts until withdrawals fall back into line with injections at a lower level of income

• This process of adjustment is what the multiplier captures — though the size of the multiplier is not required at AS Level