What’s it: Injection and leakage illustrate how income in the economy does not flow entirely in a circular flow diagram. Leakages refer to withdrawals, for example, due to savings, taxation, and imports. They are withdrawn because income is not spent on goods and services, which eventually flow out of the circular flow diagram. In other words, they can no longer be used to produce further output.
In contrast, injections represent what goes into a circular flow of income. Examples are investment, government spending, and exports.
Let’s briefly discuss a circular income flow to understand leakages and injections.
What is a circular flow of income?
A circular income flow is an economic model to illustrate how goods, services, and income flow between businesses and households in an economy. For example, companies produce products and sell them to the household sector in the product market. As compensation, they get income.
Then, the business uses the income to buy inputs in the factor market. For example, they recruit workers. In this market, the household sector supplies the input. As compensation for the inputs they provide, households earn income.
Thus, when we draw the relationship between the household and business sectors, we produce a circular flow of income. Income flows to the business sector through goods and services sold. In other words, money moves from the household sector to the business sector. And it then flows back into the household sector in the factor market when businesses buy inputs from the household sector.
How do injections and leakages affect the circular flow of income?
We need to highlight a few things about the circular flow of income (in this article, I may use the terms circular flow model or circular flow diagram interchangeably).
First, the model describes an economy. When we discuss this model, we are talking about domestically produced goods and services. For example, if goods and services are sold to the external sector, the income received represents an injection. Money from foreigners flows into the domestic economy.
Second, the principal transactions involve the business sector and the household sector. Money flows into the business sector in the product market, which then flows into the household sector in the factor market.
However, the money may not fully circulate between the two sectors. Some may flow out (withdrawn), for example, because it is not spent on domestic goods and services but saved. And some are paid as taxes by businesses and households. And some is spent on goods and services but is produced by the economy abroad (imports).
Or money flows in from external sources, so the business can use it to generate further output. For example, money flows into the business sector when selling products to the government. Or the company sells abroad (exports). Or, they collect money from financial markets to invest, so money flows from financial markets, not from selling products to the household sector. These sources represent injections.
What are examples of leakages and injections?
Savings, taxes, and imports are examples of leakage. They are drawn from circular flow diagrams, so they cannot be used to generate further output.
Meanwhile, investment, government spending, and exports are examples of injections. Money flows from the outside into a circular flow diagram.
The examples above are usually paired together. So, how much is leaked and injected can be more comparable. The leak and injection pairs include:
- Savings and investment
- Import and export
- Government taxes and spending
Savings and investment
Because it is not spent on domestic goods and services, saving represents leakage from within a circular flow diagram. It may flow into the business sector through other channels but not through the goods and services in the circular flow diagram. For example, they flow through financial markets.
To illustrate how savings eventually flow into the business sector, let’s take corporate bonds as an example. In financial markets, on the one hand, companies issue bonds to raise funds. But on the other hand, households save money by buying corporate bonds to earn income through coupons or capital gains.
And when households buy corporate bonds, money flows from the household sector to the business sector. But, unlike the transactions in the circular flow diagram, their transactions are not by exchanging money for goods and services.
The issuing companies then use the money raised from the bond issuance to finance the investment. For example, they buy machinery or production equipment. The money invested represents an injection into the circular flow diagram because it does not come from selling goods and services to the household sector but from the financial market.
Long story short, savings represent leakage from not being spent on goods and services in a circular flow diagram. Those savings pass through financial markets and are injected into the diagram when businesses use them as investments.
Government taxes and spending
Why is m tax a leakage? Due to taxes, businesses do not spend their income on buying inputs provided by the household sector in the circular flow diagram. Instead, they set aside some as tax. This also applies to households. They set aside some as taxes, some to buy goods and services, and some to save.
Then, the government uses tax revenues to finance its expenditures. For example, they buy domestic goods and services to provide public services such as education, health, and defense. Thus, taxes flow back into the circular flow diagram as injections through government spending.
Import and export
As I explained earlier, circular flow diagrams focus on domestic income, goods, and services. Thus, transactions with the external sector (exports and imports) result in injections or leakages from the circular flow diagram.
Exports represent injections. We derive our income from the external sector, not from transactions between businesses and households in the domestic market. Foreigners pay for domestic goods and services and, as such, flow into the domestic economy as injections.
On the other hand, imports represent a leakage. Domestic income flows into foreign economies when we pay for goods and services abroad. Therefore, money is drawn from a circular flow diagram.
How do leakages and injections affect the economy?
For example, if injections exceed leakage, the economy’s output increases (measured by GDP). Meanwhile, the unemployment rate decreased as increased output created more jobs in the economy.
But, on the other hand, if the leakage exceeds the injection, the economy’s output falls. Another impact is an increase in unemployment.
How these impacts work, let’s discuss them one by one.
Savings exceed investment
As leakage exceeds injection, the income circulating in the circular flow diagram is smaller. Therefore, less money is spent on domestic goods and services. Firms then responded to this situation by reducing their output as they faced weaker demand. As a result, they buy fewer factors of production and cause unemployment to rise.
We can understand this impact by recalling aggregate demand. It equals household consumption, business investment, government spending, and net exports. Assume the last two are constant.
- Aggregate demand = Household consumption + Business investment + Government spending + Net exports
When saving exceeds investment, household consumption decreases more than business investment increases. As a result, aggregate demand falls, resulting in reduced aggregate output.
Take the simplified case. The household earns $100. They spend $60 on consumption and the rest, $40, in savings.
Say they save $30 by buying corporate bonds in the domestic market. The remaining $10 they invest by buying shares in foreign financial markets. As a result, only $30 flows back as an investment (injection). Therefore, saving ($40) exceeds investment ($30).
Then, if we calculate aggregate demand, we get $90 = $60 + $30 (government spending and net exports constant). That’s a smaller amount than it should be, i.e., when a household saves $40 in domestic corporate bonds – a leakage would amount to an injection.
Investment exceeds savings
The injection will outweigh the leakage when the investment exceeds the savings. This can happen, for example, when foreign investment flows into the domestic economy. Thus, more money is available to spend on domestic goods and services.
This situation leads to an increase in output as businesses increase their production in response to increased demand. As a result, they also recruited more workers, lowering the unemployment rate.
Taxes exceed government spending.
Higher taxes than government spending means more leakage than injections. As a result, less income circulates and is spent on goods and services in the circular flow diagram.
This situation leads to a decrease in the demand for goods and services. As a result, businesses cut their output as they faced weak demand.
For example, the government collects $500 and uses only $400 as an expenditure. Thus, $500 is withdrawn from the economy (from households and businesses), and only $400 flows back into the economy. In the circular flow diagram, $100 is not spent back on goods and services.
Where’s the $100 bill? For example, it may flow to the external sector when the government pays off maturing global bonds.
Government spending exceeds taxes.
When government spending exceeds taxes, the budget leads to a surplus. As a result, more income is injected into the economy than is withdrawn.
As a result, more money is spent on goods and services in the economy. This situation leads to an increase in aggregate demand and economic output. In addition, the unemployment rate also decreased as businesses recruited more workers to increase production.
An easy way to explain this is when the government cuts taxes and increases spending, assuming that before this policy was taken, the government was running a balanced budget. This policy leads to a budget deficit – called expansionary fiscal policy.
A reduction in taxes increases disposable income, prompting households to increase spending on goods and services because more money is available. Combined with increased government spending, higher consumption increases aggregate demand in the economy.
Exports exceed imports
When exports are higher than imports, the economy reports a trade surplus. Thus, the economy generates more income from selling goods and services abroad than it spends on buying goods and services abroad.
The trade surplus contributed positively to aggregate demand. As a result, the economy’s output increases as businesses increase production to meet demand. They also recruited more workers, causing the unemployment rate to fall.
Imports exceed exports
If imports exceed exports, the leakage is more significant than the injection. In other words, the income spent on importing goods and services abroad is greater than the income generated from exports. As a result, less income circulates in the domestic economy (or in a circular flow diagram).
Since imports are higher than exports, the trade balance runs a deficit. This situation lowers aggregate demand, prompting businesses to cut production and reduce employment.
Next reading for you
- What is economic activity?
- Injections and Leakages in the Circular Flow of Income: Examples and Impacts
- Circular Flow of Income: Types and Descriptions
- Gross Domestic Product: Three Approaches, Importance, How to Calculate