The Circular Flow of Income

A leakage, also called a withdrawal, is income received that is not spent on domestically produced output. It reduces the flow.

An injection is expenditure that does not come out of current household income. It adds to the flow.

In a two sector model with a capital market:

• Saving (S) is a leakage. Income earned but not spent.
• Investment (I) is an injection. Firms borrow the savings through banks and financial markets and spend them on plant, machinery and stocks.

The condition for the flow to stay at the same level is that injections equal leakages: I = S.

What happens when they are unequal, which is the examinable part.

• If saving exceeds investment, less is being spent than is being earned. Firms find goods unsold, cut production, and lay off workers. Income falls in the next round. This is a contraction, and it is the mechanism behind the paradox of thrift in [Microeconomics and Macroeconomics].
• If investment exceeds saving, more is being spent than earned. Firms find stocks running down, raise production and employ more. Income rises. If the economy is already at full capacity, prices rise instead.

The three sector flow: adding the government

What the government adds. Two of each.

• Leakage: taxes (T). Income taken out of the circulation.
• Injection: government expenditure (G). Spending on goods and services, and transfer payments such as pensions and subsidies, put back in.

The condition now becomes S + T = I + G.

What this shows about fiscal policy, and it is the reason Module III exists. If the government spends more than it takes in tax, G exceeds T and the government is injecting more than it withdraws. That is a fiscal deficit, and its effect on the circular flow is expansionary. If it taxes more than it spends, the effect is contractionary. Every argument about the size of the deficit in [Deficits, Public Debt and the FRBM Act] is an argument about this.

The four sector flow: adding the rest of the world

What foreign trade adds.

• Leakage: imports (M). Money paid out to producers abroad, so it leaves the domestic circulation.
• Injection: exports (X). Money paid in by buyers abroad.

The full condition: S + T + M = I + G + X.

Rearranged, this says (S minus I) plus (T minus G) equals (X minus M): the excess of private saving over investment plus the government's surplus equals the current account surplus. That identity is why a large fiscal deficit tends to appear as a current account deficit, and it is the bridge between Module III and Module IV. [The Structure of the Balance of Payments] is the same idea seen from the other end.

The financial sector, in one paragraph

Households do not hand their savings to firms directly. Banks, insurers, mutual funds and the capital market collect savings and lend them to firms and to the government. That machinery is the subject of [The Financial System: Two Markets, One Job]. In circular flow terms its job is to turn the leakage of saving back into the injection of investment, and a financial system that does that badly leaves the economy operating below capacity with savings sitting idle.

A worked example: a village with four sectors

The setting. A small town. Take one year and follow 1,000 rupees.

Round one. A garment firm pays Meena 1,000 rupees in wages. That is a factor payment: money flowing from firm to household.

Round two, the leakages. Meena pays 100 rupees in tax, that is T. She buys a mobile phone imported from abroad for 200 rupees, that is M. She puts 150 rupees into a bank deposit, that is S. Total leakage 450 rupees. She spends the remaining 550 rupees on local goods and services, which is consumption, C.

Round three, the injections. The bank lends her 150 rupees deposit to a local builder who buys cement with it, that is I. The government spends the 100 rupees of tax on a school teacher's salary, that is G. And a buyer in Dubai pays 200 rupees for garments the firm exports, that is X. Total injection 450 rupees.

The result. Leakages of 450 are exactly matched by injections of 450, so the flow continues at 1,000 rupees. Every rupee that left the circulation came back into it by another door.

Change one thing. Suppose the bank cannot find a borrower and the 150 rupees sits idle. Injections are now 300 against leakages of 450. Spending in the town falls by 150 rupees, the local shopkeeper sells less, orders less, and next year Meena's firm hires fewer hands. That is a recession in miniature, and it is caused by nobody behaving badly: everybody did the prudent thing.

What the circular flow shows

Five conclusions, and an examiner asks for these under "importance of the circular flow".

1. The three measures of national income must agree, because they are one flow measured at three points. This is the foundation of [Measuring National Income].
2. The economy is interdependent. No sector can be understood alone, which is the argument of [Microeconomics and Macroeconomics] again.
3. Leakages and injections explain fluctuation. Trade cycles, treated in [Trade Cycles and Their Phases], are the flow speeding up and slowing down.
4. It shows where policy acts. Fiscal policy works on T and G, monetary policy on the S to I link through the interest rate, and trade policy on X and M. Modules III and IV are the detail of that sentence.
5. It distinguishes a stock from a flow. National income is a flow, measured over a period. Wealth and capital are stocks, measured at a moment. Confusing them is a common and costly error.

What beginners get wrong

"Money going round means the economy is growing." No. A circular flow at a constant level is an economy standing still. Growth means the circle getting larger each year.

"Saving is always good for the economy." Saving is good for the saver. For the economy it is a leakage, and it does good only if it is turned back into investment.

"Transfer payments are part of national income." A pension or a subsidy is a transfer, not a payment for current production, so it is not counted in national income. It does enter the circular flow, because the recipient spends it.

"Imports reduce national income." Imports are subtracted in the expenditure method because they were never part of domestic production, not because they are harmful. The subtraction is arithmetic, not judgment.

Limits and criticism

It is a simplification. Real economies have many sectors, inventories, and time lags between earning and spending that the diagram cannot show.

It assumes the money keeps moving. Money hoarded in cash and not deposited is a leakage with no matching injection.

It says nothing about distribution. The same flow is consistent with a very equal and a very unequal society.

The identity is always true and therefore explains nothing by itself. That leakages equal injections in the national accounts is true by construction after the event. The interesting question is at what level of income they are equal, and that requires the theory of income determination, which lies beyond this syllabus.

Quick revision

1. Circular flow: production creates income, income is spent, expenditure buys production. Output equals income equals expenditure, because they are three views of one circulation.
2. The idea goes back to Quesnay's Tableau Economique, 1758, and took its modern form in national accounting after Keynes.
3. Two flows: a real flow of factor services and goods, and a money flow of factor payments and consumption expenditure, moving in opposite directions.
4. Two sector: households and firms. Three sector: add government. Four sector: add the rest of the world.
5. Leakages: saving, taxes, imports. Injections: investment, government spending, exports.
6. Equilibrium condition: S + T + M = I + G + X. In two sectors it reduces to S = I.
7. If leakages exceed injections income falls; if injections exceed leakages income rises, or prices do if capacity is full.
8. Policy acts on the flow: fiscal policy on T and G, monetary policy on the link from S to I, trade policy on X and M.

Test yourself

1. What is the circular flow of income? Describe the two sector model. It is the continuous movement of goods, services and money payments between the sectors of an economy, in which the income generated in production is spent on output and that expenditure becomes income again. In the two sector model households own the factors of production and supply them to firms, and firms use them to produce goods and services. There are two flows in opposite directions: a real flow of factor services from households to firms and of goods and services from firms to households, and a money flow of factor payments from firms to households and of consumption expenditure from households to firms. With no saving, government or foreign trade, output, income and expenditure are equal and the flow repeats at the same level.

2. Define leakage and injection, and list them for a four sector economy. A leakage is income received but not spent on domestically produced output, which reduces the flow; an injection is expenditure that does not arise out of current household income, which adds to it. In a four sector economy the leakages are saving, taxes and imports, and the injections are investment, government expenditure and exports. The flow remains at the same level when saving plus taxes plus imports equals investment plus government expenditure plus exports.

3. What happens if leakages exceed injections? Less is being spent than is being earned, so firms find their goods unsold and their stocks rising. They respond by cutting production and employment, so incomes fall in the following round and spending falls further. The economy contracts until leakages and injections are equal again at a lower level of income. The reverse case, injections exceeding leakages, raises output and employment if there is spare capacity, and raises prices if there is not.

4. Why must national output, national income and national expenditure be equal? Because they measure the same circulation at three different points. Whatever is produced is sold or added to stocks, and its value accrues as income to the factors that produced it, in the form of wages, rent, interest and profit. That income is either spent on output or saved, and saving reappears as investment expenditure. The value of production, the sum of factor incomes and the total of expenditure are therefore three views of one quantity, which is why the production, income and expenditure methods of measuring national income must give the same answer.

5. How does the circular flow explain the effect of a fiscal deficit? Taxes are a leakage from the flow and government expenditure is an injection into it. When the government spends more than it collects in tax, it is putting more into the circulation than it takes out, so total expenditure rises, and with spare capacity output and employment rise with it. When it collects more than it spends, the effect is contractionary. This is why the size of the deficit is treated as an instrument of demand management, and why its financing, whether by borrowing from the public or from the banking system, matters for the flow.

6. Distinguish a stock from a flow, with examples from this chapter. A flow is a quantity measured over a period of time, and a stock is a quantity measured at a point of time. National income, consumption, saving, investment and exports are flows and must always be stated with a period, such as a year. Wealth, the capital stock, money supply and foreign exchange reserves are stocks and are stated as at a date. Saving is a flow; the accumulated bank balance it produces is a stock.