CIRCULAR FLOW

OF ECONOMICS
 CIRCULAR FLOW OF INCOME

The circular flow of income model is a simple way to

visualize how money constantly circulates between
households and businesses within an economy.
Households earn money through wages and salaries,
then spend that money on goods and services provided
by businesses, ensuring a continuous flow of funds that
keeps the economy thriving.
 CIRCULAR FLOW OF INCOME

The circular flow of income model is a graphical

representation of the cyclical movement of money
between households and businesses in an economy,
depicting the exchange of labor and resources for
income and the subsequent spending of that income on
goods and services produced by businesses.
 CIRCULAR FLOW OF INCOME

EXAMPLE
Imagine a small town with a bakery and its residents.
The bakery employs townspeople, paying them wages
for their work. The residents then use their earnings to
buy delicious bread and pastries from the bakery. This
ongoing exchange of money for goods and services
keeps both the bakery and the residents prosperous,
illustrating the concept of the circular flow of income.
 CIRCULAR FLOW OF INCOME

In the basic model, the circular flow of income consists

of two components:

FIRMS AND HOUSEHOLD

 CIRCULAR FLOW OF INCOME

Firms: companies that produce goods and pay wages

to employees.
 CIRCULAR FLOW OF INCOME

Households: individuals who receive wages from

firms while simultaneously purchasing the goods and
services from the firms.

BUT!
 CIRCULAR FLOW OF INCOME

In the real world, the model is a bit more complicated. It

has two extra components:

Government
Foreign Sector
 CIRCULAR FLOW OF INCOME

In the real world, the model is a bit more complicated. It

has two extra components:

Government
Foreign Sector
 CIRCULAR FLOW OF INCOME

Foreign sector: the foreign sector is responsible for

exporting and importing goods, thus facilitating an
exchange of money between the domestic economy
and the rest of the world.
 CIRCULAR FLOW OF INCOME

In the economy, goods and services move in one

direction while money flows in the other way. Goods,
money, and services are the three major flows in the
economy.
 CIRCULAR FLOW OF INCOME

The circular flow of income also represents three ways

to calculate the national income:

National Output
National Income
National Expenditure
 CIRCULAR FLOW OF INCOME

The national output shows the actual value of goods

and services produced by the economy.
 CIRCULAR FLOW OF INCOME

The national income represents the total earnings

received by people in the economy.

These include profits, dividends, wages, and rent.

For example, workers receive wages from firms.

 CIRCULAR FLOW OF INCOME

The national expenditure shows the total amount

spent on goods and services.

For example, individuals use money from their wages to

purchase goods and services from firms.
 CIRCULAR FLOW OF INCOME
DIAGRAM

The Circular flow of income diagram is a simple yet

powerful visual representation of how money and
resources move within an economy. It illustrates the
continuous exchange of goods, services, and income
between households and firms, highlighting the
interdependence of these key economic agents.
CIRCULAR FLOW OF INCOME
DIAGRAM

Income (Y) = Output (O) = Expenditure (E)

CIRCULAR FLOW OF INCOME
DIAGRAM

Income (Y) = Output (O) = Expenditure (E)

CIRCULAR FLOW OF INCOME
DIAGRAM
 TYPES OF FLOW IN
CIRCULAR FLOW OF INCOME
The circular flow consists of two main aspects:
real flow and money flow. Both concepts demonstrate
how money is exchanged for goods and services.

However, while the real flow refers to the actual flow of

goods and services, the money flow involves the
payments for services and consumption.
 THE REAL FLOW

The real flow involves two kinds of flows: the flow of

factors of production such as land and labor from
individuals to firms, and the flow of goods and services
from firms to individuals. The real flow depicts how the
economy produces and consumes products and
services.
 THE MONEY FLOW

The money flow transfers money and other forms of

credit in the economy. It happens when companies pay
wages to workers in exchange for their labor and when
individuals use their wages to pay for goods and
services.
In the money flow, income is turned into savings and
investments, then back again.
TWO-SECTOR CIRCULAR FLOW OF
INCOME MODEL
The two-sector circular flow of income model is a
simple picture of an economy in which the economy is
divided into two components: individuals and firms.

Individuals are also called households or the public,

while firms are businesses or the productive sector.
TWO-SECTOR CIRCULAR FLOW OF
INCOME MODEL

The financial sector, government sector, and overseas

sector are excluded in this model.
TWO-SECTOR CIRCULAR FLOW OF
INCOME MODEL
The model is based on two assumptions:

1. Individuals spend all their income on goods and

services without the intention of saving part of their
income.
2. Consumers purchase all output created by
companies through their consumption.
TWO-SECTOR CIRCULAR FLOW OF
INCOME MODEL
Thus, all expenses by individuals are converted into
income for businesses. Companies then spend all their
earnings on labour, capital, and raw materials,
transferring them back to individuals. This results in a
circular income flow.
 EXPANDED CIRCULAR FLOW OF
INCOME MODELS
Expanded Circular Flow of Income Models
The circular flow model can be expanded in several
ways depending on the economic sectors involved. Here
are the most common combinations of economic
factors in the circular flow.
 THREE-SECTOR MODEL

The government is added to the basic circular flow

model (two-sector model) in the three-sector circular
flow model. The financial and overseas sectors are not
included.
 THREE-SECTOR MODEL

The government sector is made up of economic

activities by the municipal, state, and federal
governments.
 THREE-SECTOR MODEL

Taxes (T) are the means through which the government

generates income from individuals and businesses.

Government spending (G), including subsidies,

transfers, and purchases of products and services, is
how the government redistributes its revenue to
businesses and individuals.
 THREE-SECTOR MODEL

Every payment has an equal and opposite reception.

That is, each flow of money has an equal and opposite
flow of commodities. As a result, the economy’s
aggregate expenditure equals its aggregate income,
which creates a circular flow.

In this model, the national income is in equilibrium when

taxes equal government spending: T=G
 THREE-SECTOR MODEL

Every payment has an equal and opposite reception.

That is, each flow of money has an equal and opposite
flow of commodities. As a result, the economy’s
aggregate expenditure equals its aggregate income,
which creates a circular flow.

In this model, the national income is in equilibrium when

taxes equal government spending: T=G
 FOUR-SECTOR MODEL

In the four-sector circular flow, the overseas sector is

added to the three-sector circular flow model. The
external sector and foreign sector are all terms used to
describe the overseas sector. The four-sector circular
flow model consists of individuals, businesses, the
government, and overseas.

The financial sector is not included.

 FOUR-SECTOR MODEL

The overseas sector is made up of:

imported (M)
and exported (X)
commodities and services, also known as foreign
commerce. Each transfer of money, once again, is
accompanied by a flow of products/services in the
other direction.
 FIVE-SECTOR MODEL

In the five-sector model, the financial sector is added

to the four-sector circular flow model. This model
includes all five economic agents: individuals,
businesses, the government, overseas, and the financial
sector.
The financial sector comprises banks and non-bank
entities that help invest individuals' funds in
businesses.
 FIVE-SECTOR MODEL

The individuals’ excess money enters the capital market

as savings, which are then invested in businesses and
the government sector. Indefinitely, the cyclic flow will
continue, and the national income reaches equilibrium
when intended saving or spending withdrawal matches
planned investment (I) or spending (S) injection into the
flow. S = I
 FIVE-SECTOR MODEL

If savings exceed investments, there will be less

production and income. On the other hand, if
investments exceed savings, this will result in more
production and income.
 FIVE-SECTOR MODEL

In the 5-sector model, the national income is in

equilibrium when:

S + T + M = I + G + X
INJECTIONS IN THE CIRCULAR FLOW
OF INCOME

Injections in the circular flow of income refer to

external factors that increase the flow of money within
an economy. These injections are essential for
stimulating economic growth and can come in the form
of government spending, investments, and exports.
INJECTIONS IN THE CIRCULAR FLOW
OF INCOME
For example, when the government invests in
infrastructure projects, it creates new jobs and
increases household income, thus injecting money into
the economy.
Similarly, when a local business exports its products to
foreign markets, it brings in additional income, which
also serves as an injection into the circular flow.
 CIRCULAR FLOW OF INCOME
LEAKAGES

Leakages, on the other hand, are factors that remove

money from the circular flow of income, leading to a
slowdown in economic activity. Common leakages
include savings, taxes, and imports.
 CIRCULAR FLOW OF INCOME
LEAKAGES
For instance, when households decide to save a portion
of their income instead of spending it on goods and
services, this money is removed from circulation,
causing a leakage.
Another example is when people pay taxes to the
government; this portion of their income is no longer
available for spending, reducing the circular flow.
 CIRCULAR FLOW OF INCOME
LEAKAGES
Finally, importing goods and services from other
countries results in money leaving the domestic
economy, which is also considered a leakage in the
circular flow of income.
 CIRCULAR FLOW OF INCOME
LEAKAGES

Leakages in the circular flow of income are the

economic activities that remove money from the
circulation within an economy, causing a reduction in
the overall flow of income. The primary types of
leakages include savings (S), taxes (T), and imports (M).
 CIRCULAR FLOW OF INCOME
EQUILIBRIUM AND DISEQUILIBRIUM
If the total leakages in the economy equal the total
injections, then the circular flow of income will be in
equilibrium.

Total leakages = Savings(S) + Taxes(T) + Imports(M)

Total Injections = Investment(I) + Government
Spending(G) + Exports(X)
Total leakages = Total Injections
 CIRCULAR FLOW OF INCOME
EQUILIBRIUM AND DISEQUILIBRIUM
If the total number of leakages does not equal the total
number of injections, it leads to disequilibrium.

Savings(S) + Taxes(T) + Imports(M) ≠ Investment(I) +

Government Spending(G) + Exports(X)
 CIRCULAR FLOW OF INCOME
EQUILIBRIUM AND DISEQUILIBRIUM
When the government increases its spending, consumer
spending, production, and employment will also rise,
resulting in economic growth or expansion:

Savings(S) + Taxes(T) + Imports(M) < Investment(I) +

Government Spending(G) + Exports(X)
 CIRCULAR FLOW OF INCOME
EQUILIBRIUM AND DISEQUILIBRIUM
When people hoard money in their savings accounts,
production, spending, and employment will decrease,
resulting in a reduction of economic activities:

Savings(S) + Taxes(T) + Imports(M) > Investment(I) +

Government Spending(G) + Exports(X)
 CIRCULAR FLOW OF INCOME
EQUILIBRIUM AND DISEQUILIBRIUM
If disequilibrium occurs in the circular flow of income,
adjustments in government expenditure and savings will
restore equilibrium.
CIRCULAR FLOW OF INCOME
EXAMPLE
 TWO-SECTOR MODEL:
HOUSEHOLDS AND BUSINESSES
Let's start by considering a simple two-sector model of
the circular flow of income. Imagine a small town with a
popular bubble tea shop, a grocery store, and several
households. The bubble tea shop sells drinks to the
grocery store, which in turn sells them to households.
 TWO-SECTOR MODEL:
HOUSEHOLDS AND BUSINESSES
The households pay for the bubble tea, and the grocery
store uses that money to pay the bubble tea shop. At
the same time, both the bubble tea shop and grocery
store employ people from the households, paying them
wages for their labor. The households then use their
income to purchase goods and services from
businesses, such as the bubble tea shop and the
grocery store.
 THREE-SECTOR MODEL:
ADDING THE GOVERNMENT
As we expand our model to include the government, we
introduce taxes, government spending, and transfer
payments. In this scenario, the government collects
taxes from both households and businesses, which can
be seen as a leakage from the circular flow of income.
 THREE-SECTOR MODEL:
ADDING THE GOVERNMENT
However, the government also spends money on public
goods and services, such as building a new park, and
provides transfer payments, like unemployment
benefits, injecting money back into the economy.
 FOUR-SECTOR MODEL:
INCORPORATING FOREIGN TRADE
We add foreign trade into the mix, accounting for
exports and imports. The bubble tea shop may decide
to export its products to other countries, bringing in
foreign income and boosting the local economy.
Conversely, the grocery store may import some
products from other countries, such as exotic fruits.
The money spent on these imports will leave the local
economy and become a leakage.
FIVE-SECTOR MODEL: INTRODUCING
FINANCIAL INSTITUTIONS
Finally, we incorporate financial institutions like banks
into our model. These institutions play a crucial role in
the circular flow of income by facilitating savings,
investments, and loans
FIVE-SECTOR MODEL: INTRODUCING
FINANCIAL INSTITUTIONS
For example, households may save a portion of their
income in a bank, reducing their spending on goods and
services. The bank then lends this money to businesses,
like the bubble tea shop, which can use it to expand its
operations or invest in new equipment. This investment
becomes an injection into the circular flow of income.
CIRCULAR FLOW OF INCOME -
KEY TAKEAWAYS
The circular flow of income model is a graphical
representation of the exchange of money, labor, and
resources between households and businesses in an
economy.
The basic model has two main components: firms
(businesses) and households (individuals).
 CIRCULAR FLOW OF INCOME -
KEY TAKEAWAYS
The model can be expanded to include the
government, foreign trade, and financial institutions,
creating a more comprehensive picture of an
economy's overall health and growth.
Injections (such as government spending,
investments, and exports) and leakages (such as
savings, taxes, and imports) can impact the flow of
money within an economy, affecting its overall growth
and stability.
 CIRCULAR FLOW OF INCOME -
KEY TAKEAWAYS
Equilibrium in the circular flow of income occurs when
total leakages equal total injections; disequilibrium
can lead to economic expansion or contraction.
The model highlights the interdependence between
households, businesses, and other economic agents,
demonstrating the importance of understanding their
relationships.
CIRCULAR FLOW OF INCOME -
KEY TAKEAWAYS
The circular flow of income model can be used to
calculate national income through national output,
national income, and national expenditure.
Understanding the circular flow of income is crucial
for comprehending an economy's overall health and
growth, informing economic policy and decision-
making.
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