the circular flow of income and spending

Two Sector Model

The circular flow of income and spending illustrates the linkages between different sectors of the
macro-economy. 

The British economy comprises millions of individual economic units - households, firms and
government. Together their decisions generate spending, output and income - three ways of measuring
the total economic activity. The circular flow of income shows flows of goods and services and factors
of production between firms and households.

Households provide their labour for firms who produce goods and services. In return people in work
receive payments, such as wages, which in turn are spent on the output of firms. Not all of current
income is spent - some is saved. This represents a leakage from the circular flow.

In addition to consumer spending, businesses also carry out capital investment spending (e.g. on new
plant & machinery and buildings). Investment demand is an injection of money to the circular flow of
income, as it does not originate from consumers' current income

In neoclassical economics, the terms circular flow of income or circular flow refer to a simple economic
model which describes the reciprocal circulation of income between producers and consumers. [1][2] In
the circular flow model, the inter-dependent entities of producer and consumer are referred to as
"firms" and "households" respectively and provide each other with factors in order to facilitate the flow
of income[1]. Firms provide consumers with goods and services in exchange for consumer expenditure
and "factors of production" from households. The circular flow model has been criticized by ecological
economists for failing to show that the economy has a physical root in its larger environment, and
hence for being at the root of the neoclassical models' inability to conceptualize effectively
environmental constraints and costs, such as global climate change and the loss of ecosystem services
that leads to uneconomic growth. Economists advancing this idea include Herman Daly; Joshua Farley;
Robert Costanza; and political theorist Eric Zencey [3].
The circle of money flowing through the economy is as follows: total income is spent (with the
exception of "leakages" such as consumer saving), while that expenditure allows the sale of goods and
services, which in turn allows the payment of income (such as wages and salaries). Expenditure based
on borrowings and existing wealth – i.e., "injections" such as fixed investment – can add to total
spending.

In equilibrium, leakages equal injections and the circular flow stays the same size. If injections exceed
leakages, the circular flow grows (i.e., there is economic prosperity), while if they are less than
leakages, the circular flow shrinks (i.e., there is a recession).

More complete and realistic circular flow models are more complex. They would explicitly include the
roles of government and financial markets, along with imports and exports. To the extent that they
remain circular flow models, however, they do not effectively model the one-way flow of energy
through the economy. (That energy flow must be one-way and not a circular flow is a consequence of
the second law of thermodynamics, the law of entropy. This failure ultimately allows neoclassical
models to treat environmental values as a subcategory of economic values, rather than seeing
economic activity emplaced as a subcategory of human activity which in turn is a subcategory of
activity within ecosystems.

Labor and other "factors of production" supplied by households are sold on resource markets. These
resources, purchased by firms, are then used to produce goods and services. The latter are sold on
product markets, ending up in the hands of the households, helping them to supply resources. Again,
critics say that it is unrealistic and dysfunctional to model the economy as if energy and other
resources were extracted from households instead of planetary systems. This criticism is further
elaborated within an article in the Encyclopedia of Earth

Assumptions

 The basic circular flow of income model consists of six assumptions:

 The economy consists of two sectors: households and firms.
 Households spend all of their income (Y) on goods and services or consumption (C). There is no
saving (S).
 All output (O) produced by firms is purchased by households through their expenditure (E).
 There is no financial sector.
 There is no government sector.
 There is no overseas sector.
 It is a closed economy with no exports or imports.

In the simple two sector circular flow of income model the state of equilibrium is defined as a situation
in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change,
that is:

Y=E=O

This means that the expenditure of buyers (households) becomes income for sellers (firms). The firms
then spend this income on factors of production such as labour, capital and raw materials,
"transferring" their income to the factor owners. The factor owners spend this income on goods which
leads to a circular flow of income.
Five Sector Model

Table 1 All leakages and injections in five sector model

LEAKAGES INJECTION

 Saving (S) Investment (I)

 Taxes (T) Government Spending (G)
 Imports (M) Exports (X)

The five sector model of the circular flow of income is a more realistic representation of the economy.
Unlike the two sector model where there are six assumptions the five sector circular flow relaxes all six
assumptions. Since the first assumption is relaxed there are three more sectors introduced. The first is
the Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing
(savings from households) and lending of money. In terms of the circular flow of income model the
leakage that financial institutions provide in the economy is the option for households to save their
money. This is a leakage because the saved money can not be spent in the economy and thus is an idle
asset that means not all output will be purchased. The injection that the financial sector provides into
the economy is investment (I) into the business/firms sector. An example of a group in the finance
sector includes banks such as Westpac or financial institutions such as Suncorp.

The next sector introduced into the circular flow of income is the Government Sector that consists of
the economic activities of local, state and federal governments. The leakage that the Government
sector provides is through the collection of revenue through Taxes (T) that is provided by households
and firms to the government. For this reason they are a leakage because it is a leakage out of the
current income thus reducing the expenditure on current goods and services. The injection provided by
the government sector is Government spending (G) that provides collective services and welfare
payments to the community. An example of a tax collected by the government as a leakage is income
tax and an injection into the economy can be when the government redistributes this income in the
form of welfare payments, that is a form of government spending back into the economy.

The final sector in the circular flow of income model is the overseas sector which transforms the model
from a closed economy to an open economy. The main leakage from this sector are imports (M), which
represent spending by residents into the rest of the world. The main injection provided by this sector is
the exports of goods and services which generate income for the exporters from overseas residents. An
example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter
of the wool (the farmer) therefore more money enters the economy thus making it an injection.
Another example is China processing the wool into items such as coats and Australia importing the
product by paying the Chinese exporter; since the money paying for the coat leaves the economy it is a
leakage.

In terms of the five sector circular flow of income model the state of equilibrium occurs when the total
leakages are equal to the total injections that occur in the economy. This can be shown as:

Savings + Taxes + Imports = Investment + Government Spending + Exports

OR

S + T + M = I + G + X.

This can be further illustrated through the fictitious economy of Noka where:
S + T + M = I + G + X
$100 + $150 + $50 = $50 + $100 + $150
$300 = $300

Therefore since the leakages are equal to the injections the economy is in a stable state of
equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of
equilibrium the sum of total leakages does not equal the sum of total injections. By giving values to the
leakages and injections the circular flow of income can be used to show the state of disequilibrium.
Disequilibrium can be shown as:

S+T+M≠I+G+X

Therefore it can be shown as one of the below equations where:

Total leakages > Total injections

$150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + 150 (X)

Or

Total Leakages < Total injections

$50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + 150 (X)

The effects of disequilibrium vary according to which of the above equations they belong to.

If S + T + M > I + G + X the levels of income, output, expenditure and employment will fall causing a
recession or contraction in the overall economic activity. But if S + T + M < I + G + X the levels of
income, output, expenditure and employment will rise causing a boom or expansion in economic
activity.

To manage this problem, if disequilibrium were to occur in the five sector circular flow of income
model, changes in expenditure and output will lead to equilibrium being regained. An example of this
is if:

S + T + M > I + G + X the levels of income, expenditure and output will fall causing a contraction or
recession in the overall economic activity. As the income falls (Figure 4) households will cut down on
all leakages such as saving, they will also pay less in taxation and with a lower income they will spend
less on imports. This will lead to a fall in the leakages until they equal the injections and a lower level
of equilibrium will be the result.

The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the levels of
income, expenditure and output will greatly rise causing a boom in economic activity. As the
households income increases there will be a higher opportunity to save therefore saving in the financial
sector will increase, taxation for the higher threshold will increase and they will be able to spend more
on imports. In this case when the leakages increase they will continue to rise until they are equal to
the level injections. The end result of this disequilibrium situation will be a higher level of equilibrium.
Government spending on state provided goods and services is injected into the circular flow and
taxation will leak from it.

International trade plays an increasingly important role in shaping the performance of the British
economy. The value of exports sold overseas will be injected into the circular flow, whilst spending by
UK consumers and businesses on imported products represent a leakage from the flow. (Goods and
services are coming into the economy to satisfy domestic demand, but money to pay for them is
flowing out of the economy).