The circular flow of income

The Circular Flow of Income


  • The circular flow of income is a basic model in economics that describes how money moves through an economy.
  • It illustrates the relationships between households, firms, and the government.

Key Components

  • Households: Households offer labour and other factors of production to firms and are compensated in return (wages, rent, interest).
  • Firms: Firms produce goods and services, paying households for their resources and selling the outputs back to the households.
  • The Government: The government sets and collects taxes and provides public services.
  • Financial Markets: These are where savings and investments occur, influencing spending and income generation.
  • External Sector: Represents the foreign sector, which includes international trade, foreign investment, and capital flows.

Two Types of Flows

  • Real Flows: These include the flow of resources and goods and services in the economy.
  • Money Flows: Refer to the transfer of money for goods, services, or resources.

Leakages and Injections

  • Leakages (withdrawals): Include taxes, savings and imports, which remove spending power from the circular flow.
  • Injections: Include government spending, investments, and exports, providing extra spending power into the flow.

Models of Circular Flow of Income

  • Two-sector model: This is the simplest form involving households and firms only.
  • Three-sector model: Includes the government in addition to households and firms.
  • Four-sector model: This model includes the foreign sector, making it an open economy model.

Importance of the Circular Flow of Income

  • It helps to visualise how different sectors of an economy interact.
  • It is used to model the equilibrium level of national income.
  • Assists to illustrate the concept of GDP and understand economic fluctuations.

Limitations of Circular Flow of Income

  • It assumes all income is spent, not taking into account hoarding of cash.
  • It does not account for technological progress and its effects on productivity.
  • It often overlooks the informal economy and black markets.