The Circular Flow of Income

Definition 

The Circular Flow of Income (CFI) refers to the continuous circulation of income and expenditure among the economic agents. 

A Closed Economy 

The following illustrates the CFI through a simple model of an economy, which excludes the Government Sector and Foreign Trade Sector.

1. Households provide firms with land, labour and capital 
2. Firms employ the factors of production and make payments to households in the form of rent, wages and salaries, interest and profits. 
3. Households use their income to buy goods and services form firms. 

A More Realistic Model 

The following diagram illustrates the CFI in an economy with Households, Firms, the Government and Foreign Trade Sectors. 

Remember, the four sector model includes the income withdrawn from and injections into the economy. 

The following assumptions will help you to study the realistic model. 

1. An economy not only consists of Households and Firms, but also includes the Government 
2. Countries also take part in trade with other countries 
3. Firms often invest in the production of capital goods 
4. Households do not always spend all their income but also save a proportion of their income 

Injections 

The addition of income to the CFI is known as Injections. Injections take the form of; 

1. Investment (I) 
2. Government Spending (G) 
3. Exports (X) 

1. Investment (I) 

Investment of firms in the production of capital goods is an addition to the CFI. 

2. Government Spending (G) 

Government is the major buyer and employer in the economy. It spends on goods and services and salaries and wages. 

Majority of income is injected into the economy from the government. 

3. Exports (X) 

Domestic households and firms receive income by exporting goods and services abroad. It is an injection of income into the economy. 

Leakages 

The outflow of income from the CFI is known as Leakages. Leakages take the form of; 

1. Savings (S) 
2. Taxes (T) 
3. Imports (M) 

Savings (S) 

Saving refers to that part of consumer income that is kept aside for future use. It is a leakage as it does not come into the CFI in the form of household spending. 

Taxes (T) 

Taxes levied on income and spending is a withdrawal form the CFI. 

Imports (M) 

Import of goods and services is followed by an outflow of currency. Therefore, it is a leakage. 

Equilibrium 

Equilibrium refers to a state of balance. The national Income is said to be in Equilibrium when Injections are exactly equal to Leakages. Therefore, (I+G+X) = (S+T+M). 

When (I+G+X) > (S+T+M), the value of CFI increases leading to a rise in employment and National Income. 

When (S+T+M) > (I+G+X), the value of CFI decreases leading to a fall in employment and National Income. 

The Government Influence on the CFI 

The changes in the value of CFI are a clear indicator of government’s preferences and economic policies regarding; 

1. pattern of expenditure 
2. income distribution 
3. the level of employment etc 

In order to change the value of the CFI, the government uses Fiscal and Monetary policies. 

For example, when the government wishes to increase the level of employment, it can either; 

1. increase its spending and investment or 
2. reduce saving and taxation. 

But, in this case, an increase in the value of CFI pulls up Inflation due to the rise in aggregate demand. Therefore, the government either; 

1. reduces injections (Investments, Government Spending and Exports) or 
2. increases Leakages (Savings, Taxes and Imports)