4.2 Introduction to the circular flow of income

Learning objectives

4.2.1Circular flow of income• Circular flow of income in a closed economy and an open economy: the flow of income between households, firms and government and the international economy 4.2.2Injections and leakages• Injections and leakages (multiplier not required)4.2.3Circular flow equilibrium• Equilibrium and disequilibrium (marginal and average propensities not required)

In a closed economy, households provide factors to firms and receive income, then spend on firms’ output. Government collects taxes and spends; in an open economy exports and imports connect the flow to the international sector.

Real flows are resources and goods; money flows are wages, rent, interest, profits and expenditure. Each receipt for one sector is spending or income for another.

A household receives wages from a firm, buys its output, pays tax to government and may buy an imported good; exports bring spending into the domestic flow.

The circular flow is not a claim that every pound circulates instantly or that saving disappears; it describes linked flows over a period.

Investment, government spending and exports are injections into the circular flow. Saving, taxation and imports are leakages (withdrawals).

In a simple model, total injections equal total leakages when the circular flow is stable. A change in one component affects income and output through linked spending, even when the multiplier is not calculated.

A rise in government infrastructure spending is an injection; households saving more is a leakage. If injections exceed leakages, national income tends to expand initially.

A leakage is not automatically harmful and an injection is not automatically beneficial; effects depend on capacity, inflation and what is spent.

An open economy with government is in circular-flow equilibrium when total planned injections equal total planned leakages. Individual pairs do not have to match: an investment-saving gap can be offset by the government budget or trade balance.

I+G+X=S+T+M\quad\text{or}\quad (I-S)+(G-T)+(X-M)=0

| Net planned flow | Pressure on national income |\n|---|---|\n| $I+G+X>S+T+M$ | Excess injections: income/output tends to rise |\n| $I+G+X=S+T+M$ | Equilibrium: no built-in pressure to change |\n| $I+G+X<S+T+M$ | Excess leakages: income/output tends to fall |

Suppose $I=150$ , $G=200$ , $X=100$ , while $S=100$ , $T=180$ and $M=120$ . Injections are $450$ and leakages are $400$ , so there are net injections of $50$ and national income tends to rise. Equilibrium would require one or more flows to adjust until the £50 gap closes.

Equilibrium does not require $I=S$ , $G=T$ and $X=M$ separately, and it does not mean full employment, zero inflation or an equal distribution of income. Multiplier and marginal/average propensity calculations are outside this objective.

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—4.3 Aggregate Demand and Aggregate Supply analysisRead

4.2 Introduction to the circular flow of income

Learning objectives

The circular flow tracks income between households, firms, government and the rest of the world

Injections add spending to the circular flow; leakages withdraw it

Find circular-flow equilibrium and disequilibrium

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