Investment, government spending, and exports are three injections in the economy. They contribute to increasing the demand for goods and services in the economy and, therefore, stimulate more job and income creation.
What is injection? An injection is putting funds into the economy or, specifically, into a circular flow of income diagram. So, if we count how much is being injected into the economy, we add up investment, government spending, and exports.
What is a circular flow of income? It is an economic model to describe how goods, services, and money flow among four economic actors: households, businesses, government, and external. Its simplest model only uses households and businesses as representations.
Injections are essential to increase the income flowing in the economy. For example, when a business invests, it’s an injection. Their investment creates more goods and services, jobs, and household income. An increase in income drives more demand for goods and services, which in turn creates more jobs and income.
Then, leakage is a term related to the injection. Leakage represents the withdrawal from a circular flow of income. Three examples are taxes, imports, and savings. When withdrawn, less funds flow in a circular stream. All three are paired together with government spending, exports and investment. Thus, the leakage from the circular flow can enter again as an injection.
- Government spending vs. Tax
- Export vs. Import
- Investment vs. Savings
Why is injection important in the economy?
An injection is important in influencing economic growth. It will increase GDP by adding funds to the economy to recirculate. And an increase in GDP indicates a growing economy where output increases. It also creates more job and income opportunities.
However, we must compare injection with leakage to measure the final outcome on the economy. When injection exceeds leakage, net funds go into the circular flow. That contributes to increased output and economic growth.
But conversely, if the injection is less than the leakage, more funds are going out than coming in. This situation leads to a shrinking output and a contraction in growth.
What are the three injections in economics?
Economists describe three types of injection, including:
- Government spending
Investment is spending by the business sector for capital goods. For example, when businesses invest, they spend money on production machinery and equipment. Or they build a new factory.
Therefore, when businesses invest, we expect their output to increase. In addition, we also hope they recruit more workers, lowering unemployment. This situation ultimately leads to more income being created in the economy.
Investment is an injection because it injects income into the economy by creating new capital or replacing existing capital, encouraging more output, jobs, and income.
Where does the business get funds for investment? There are two sources: internal capital and external capital. Internal capital comes from retained earnings, which are profits the company decides not to distribute as dividends. Instead, they keep those profits as internal capital to support future growth.
Meanwhile, external sources come from several sources. First, a business might borrow from a bank. Second, they sell shares to the public through an initial public offering (IPO). Third, they borrow from the public by issuing bonds.
How is investment related to saving? Households save their income in addition to what is spent. For example, they put it in a time deposit. Banks then channel their money as loans. Investment loans to businesses are among them.
In addition, households may also buy securities issued by companies. For example, they buy stocks or corporate bonds. Ultimately, household savings flow into businesses. While businesses use the funds collected from issuing securities for investment, households receive dividends, capital gains, or coupons as a return.
But, unlike investment, savings represent leakage because the income is not spent on buying goods and services. Instead, it flows out of a circular flow of income. Therefore, an increase in savings does not contribute to creating more demand for goods and services.
Then, when households place their savings in the domestic financial market, it is reinjected into the circular flow as an investment. So, savings can be an injection if it is funneled back in a circular flow through financial markets and used for investment.
Government spending is an injection because it is spent on goods and services to provide public services such as education, health, defense, and infrastructure. As a result, increased government spending creates more demand for goods and services. As a result, businesses responded by increasing output and hiring more workers.
How is government spending financed? The government relies on taxes to finance its spending. Unlike government spending, taxes represent leakage. It is withdrawn from the economy because it is not spent on goods and services. However, when the government uses taxes to finance expenditures, these expenditures flow back into the circular flow as injections.
Exports flow income into the domestic economy from selling goods and services abroad. When businesses sell their products overseas, they derive revenue from foreign buyers. Money is injected from the destination country into the domestic economy. The business then uses the export earnings to finance operations, investments, dividends, and profits.
Meanwhile, imports work in reverse with exports. Imports represent leakage as money flows from the domestic economy abroad to pay for the foreign products we buy. There is less money at home and, therefore, less to circulate in the economy to create more output.
How do injections affect the economy?
Injection and leakage work in reverse. Likewise, both have opposite impacts on the domestic economy. Injection contributes to creating more output and income for the domestic economy. This is because increased injection increases GDP and multiplier value. The opposite effect applies when leakage increases. Thus, the overall impact on the economy depends on how significant the injection is compared to the leakage.
In the real world, the injection may be larger or smaller than the leak. And that has significant consequences for circular flows and output within the economy.
Injection exceeds leakage
The injection is more significant than the leakage resulting in a more significant circular flow. GDP increases. Likewise, more jobs and income are created.
Take government spending and taxes as an example. Injection exceeds leakage when government spending is greater than taxes, ceteris paribus. Consequently, more goods and services are demanded than are spent on paying taxes.
Assume government spending is $100. Meanwhile, the tax is $90, which is assumed to come only from the household. Households cannot spend $90 on goods and services because they have to use it to pay taxes. So instead, the government spends $100 to buy goods and services. As a result, a net of $10 ($100 – $90) is spent on goods and services in the economy. This net $10 creates a multiplier in the economy as it stimulates businesses to increase production to fill it.
In other examples, exports exceed imports. The circular flow increases because the injection is greater than the leakage. For example, when the domestic economy exports $200 and imports $140, an additional $60 of revenue ($200 – $140) flows into the domestic economy. Finally, GDP increases by $60, ceteris paribus.
- GDP = Household consumption + Business investment + Government spending + (Exports – Imports)
Less injection than leakage
The size of the circular flow will decrease when the leakage is greater than the injection. For example, imports are higher than exports. Because imports exceed exports, more income is spent on foreign products than flows in from abroad. As a result, on a net basis, less income flows into the domestic economy to be spent on goods and services.
Take saving and investing as another example. Leakage exceeds injection when savings exceed investment. Thus, more savings do not flow back into the economy as an investment. As a result, businesses buy fewer capital goods and reduce their production. They also buy less labor, resulting in an increase in unemployment and a decrease in household income. Finally, this situation leads to a decline in output, employment, and income in the economy.