Circular Flow of Income: Types and Descriptions

What’s it: A circular flow of income model shows you the economy’s movements of spending and income.

Brief overview:

Output flows from businesses to households in the goods market. While money flows from households to businesses. In this market, households are buyers, and businesses are suppliers.
Businesses use the money to buy inputs in factor markets. Take the labor market, for example. Businesses act as buyers and households act as sellers. Labor services flow from households to businesses. Instead, money flows from businesses to households.

In the economy, such flow is more complicated. It involves four macroeconomic sectors:

Household
Business
Government
Foreign

And remember, the foreign sector also basically consists of households, businesses, and government.

Why is it important

The model is essential for showing that aggregate output is equivalent to aggregate expenditure and aggregate income. That’s why the calculating gross domestic product (GDP) can use three different approaches: output, income, and expenditure.

Output approach – measures the value of all goods and services produced in the country.
Income approach – measures the amount of all income earned in the economy, including wages, interest, and profits.
Expenditure approach – measures the amount of all spending on goods and services, including consumption, investment, government purchases, and net exports.

Assumptions and models

Three models explain the circular flow of income, where the difference lies in the government’s role and the external sector, whether it exists or not.

Two-sector economic model only comprises households and businesses, without government or foreign sectors.
Three-sector economic model involves households, businesses, and government, without the foreign sector.
Four-sector economic model consists of four main sectors: households, business, government, and the foreign sector.

Two-sector economic model

The model assumes the economy consists of two sectors: households and businesses. So:

The government does not take a role. And because of that, the economy does not involve public spending, taxes, subsidies, and social security.
The economy is autarchy (closed economy) because it doesn’t involve international trade. There are no exports or imports.

The household sector’s role: In the goods market, households are the sole buyers of goods and services from the business sector. They spend the income they receive or save part of it.

On the other hand, they are the sole supplier of production factors (land, labor, capital, and entrepreneurship) in the factor market. As compensation, they receive income (rent, wages, interest, and profits).

The business sector’s role: In the goods and services market, businesses are the sole supplier and seller of goods and services. They sell products to the household sector and receive money as income.

In factor markets, they are the sole buyers of factors of production provided by the household sector. They hand over money to the household sector as compensation for the use of production factors.

Assumption of model 1: Household spends all income on expenditure. No savings. Businesses don’t invest either.

Because they do not save, households spend all their income on buying goods and services in the goods market. Money flows from the household sector to the business sector.

Businesses use the money from the sale of goods and services to buy inputs in factor markets. In this market, money flows from the business sector to the household sector.

Assumption of model 2: Households spend part of their income on consumption and the rest on savings. Businesses invest in capital goods.

If it is not saving, the household does not spend all of its income to buy the output of goods and services. That means some goods are unsold, whose value is equal to the amount of savings.

Take a simple example. The value of business output and household income is IDR1,000. Say, household consumption is IDR 800 and savings IDR 200. Since households spend IDR800 to buy goods, there is an unsold output of IDR200.

Where will the savings flow? The circular flow then involves financial markets. This market facilitates the flow of savings from the household sector and investment by businesses. Suppose we add saving and investment to the circular flow. In that case, the equilibrium level between income and output is maintained at its original level.

In the example above, say, the household put IDR200 savings in corporate bonds. Furthermore, businesses, which issue bonds use the money for capital investment in maintaining their current level of output.

Three-sector economic model

The model assumes a closed economy, but there is a role for the government. Hence, circular flow involves three sectors: households, business, and government.

The government plays roles of:

Collecting taxes from the household and business sector
Purchasing goods and services from the business sector
Using production factors from the household sector

How it works: In a factor market, households supply factors of production, and businesses buy them to produce goods and services. In the goods market, households act as buyers, and companies act as sellers.

Households get income from the provision of factors of production and government transfers. Likewise, businesses derive income from the sale of goods and services. And, both sectors set aside a portion of their income to pay taxes to the government.

The government uses its income to buy goods and services from the business sector. It uses production factors from the household sector. Then, some of the spendings flow to the household sector through transfer payments. Payments can take forms such as welfare benefits and unemployment benefits.

Four-sector economic model

This model is the most realistic compared to the previous two. You can see, almost all countries take part in international trade, even for a country like North Korea. They buy goods from abroad and export goods to international markets.

Economic activity and circular flow involve four sectors:

Household sector
Business sector
Government sector
Foreign sector or external sector

How it works: Here, I will discuss only the external sector’s role in the circular flow because I have discussed the other three sectors before.

The involvement of the external sector indicates a country is adopting an open economy. Domestic economic transactions with the foreign sector involve exports, imports, and investment.

Exports represent domestic output that is sold abroad. Accordingly, income will flow from abroad to the domestic economy.
Imports represent the purchase of goods and services from the external sector by the domestic economy. As payment, money (income) flows from domestic to abroad.
Investment consists of direct investment and portfolio investment. Investment inflows carry money from the foreign sector into the domestic economy. In contrast, outflows take money from the domestic economy to the external sector.

Suppose we add up the income from the four sectors. In that case, we will get the aggregate income figure, which will equal aggregate expenditure. Aggregate expenditure for an open economy is:

Y = C + I + G + (X – M)

Where,

Y = Aggregate expenditure
C = Consumption expenditure
I = Investment expenditure
G = Government expenditure
X – M = net exports, i.e. exports (X) minus imports (M)

Leakage and injections in the economy

Leakage occurs when the income is not used for spending on domestic goods and services. The total leakage in the economy is the sum of:

Savings – Households save part of their income. Hence, saving reduces spending on goods and services in the economy.
Taxes – It reduces consumption spending. Households cannot use all their income to buy goods and services because they have to pay taxes. Likewise, a business cannot use its income to purchase production factors because it has to pay taxes.
Imports – it represents the outflow of income from the domestic economy to the foreign sector. Domestic consumers (households, businesses, and government) use their income to pay for imported products.

Injection represents the money addition that goes to the circular flow of income. The total injection is the sum of:

Investment – when foreigners invest in the domestic economy, money flow from abroad to domestic.
Government spending – the government injects money into the circle through programs such as transfer payments to the household sector and subsidies to the business sector.
Exports – when selling goods to the external sector, the domestic economy earns income (money) as payment.

Income flow is stable when the total leakage equals the total injection. If the injection is higher than the leakage, the level of national income (GDP) will increase. But, if the leakage is higher than the injection, the national income will decrease.

Circular Flow of Income: Types and Descriptions

Why is it important