What Is the Circular Flow Of Income?

The circular flow of income is a neoclassical economic model depicting how money flows through the economy. In its simplest version, the economy is modeled as consisting only of households and firms. Money flows to workers in the form of wages and money flows back to firms in exchange for products. In short, an economy is made up of countless circular flows of income (or money).

Key Takeaways

  • Circular flow of income is a model of income going from firm to household and vice versa in a loop.
  • The model can be much more complex including things such as leakages and additions to income from other sectors of the economy.

Understanding Circular Flow Of Income

Most, if not all, people go to work daily to earn a living. The money that is earned is used to purchase goods and services from businesses such as food, clothes, rent, basic commodities, entertainment services, health and wellness products, etc. The income earned daily flows back to businesses continuously in a cycle known as the circular flow of income.

Businesses and companies manufacture goods or provide services to consumers. To increase sales and profits, these companies use factors of production—labor, capital, and land—to run their operations and grow their businesses. In return for their services, hired labor is given a wage or salary, known as income. The income received is used by households and individuals to purchase the goods and services produced by these businesses. The businesses use the proceeds from the sales to produce more products and pay workers for their labor.

Enhancing Circular Flow

The circular flow of income described above is the most simplistic illustration of the interdependence of two sectors in the economy. However, actual money flows through the economy are far more complicated. Economists have expanded on the ideas of the circular flow of income model to better depict the complexity of modern economies by including more sectors that affect money flow. These sectors can then be conceptualized as the components of total nation income or output (GDP).

In addition to the household sector that engages in consumption spending (C) and the business sector that produces the goods, two sectors that can also be included in the circular flow of income include the government sector and the foreign sector. The government injects money into the circle through government spending (G) on things like welfare programs and infrastructure. Money is also added to the circular flow through exports (X) which involves foreign entities purchasing goods from the economy. Businesses that invest (I) money to purchase capital stocks contribute to the flow of income in the economy.

Just as money is injected into the economy, money can also be withdrawn or leaked through a number of activities. Taxes (T) imposed by the government reduce the flow of income. Money that is used to pay foreign entities for goods and services through imports (M) also constitutes a leakage. Finally, savings (S) of businesses which could otherwise have been invested leads to a decrease in the circular flow of an economy’s income.

By tracking the injections into and withdrawals from the circular flow of income, the government can calculate its national income which is the wages and other forms of income received by households for their services.

The level of injections is the sum of government spending (G), exports (X) and investments (I). The level of leakage or withdrawals is the sum of taxation (T), imports (M) and savings (S). When G + X + I is greater than T + M + S, the level of national income (GDP) will increase. On the other hand, when the amount of leakage is greater than the amount injected into the circular flow, the national income will decrease. The circular flow of income is said to be balanced when withdrawal equals injections.

In addition, the GDP, calculated as C + G + I + (X – M), can be drawn from the circular flow of income. GDP would decrease if businesses decided to produce less, leading to a reduction in household spending. Following the two-sector circular flow of income, GDP could also decrease if households decided to spend less, resulting in businesses reducing their level of production.