Gross Domestic Product (or GDP) is the commonest measure of an economy’s national income and includes the output of all goods and services produced over a period of time – usually one year.
Income in an economy circulates between its two key sectors, households and firms.
Households supply factors of production to firms, including labour, capital, land and enterprise. In return they receive factor incomes – wages, interest, rent, and profits.
This income is converted into expenditure to buy goods and services from firms. Consumer demand is met by firms, as they produce an output of goods and services. The firms receive an income in the form of revenue. With this income firms pay for the factors they use.
However, households are likely to save some of their income, which is a leakage out of the circular flow and makes the economy smaller. Taxes paid to the government are also a leakage, along with spending on imports from abroad.
These leakages leave the circular flow through three sectors – deposits into the financial sector, tax payments to government, and payments going abroad. While these leakages make the economy smaller, injections into the circular flow make the economy bigger.
As firms produce, machinery wears out or better technology becomes available. Firms may borrow to spend on these capital goods, creating investment, which is an injection into the circular flow.
Government spending on merit goods and public goods is a further injection, along with overseas spending on a country’s exports. The whole economy is in a stable equilibrium, when leakages are balanced by injections.
Leakages reduce the size of national income, while injections increase it. It is only necessary for all injections to equal all leakages, not for the ‘pairs’ to equal each other – for example, saving does not need to equal investment.
The circular flow can help understanding how economic policy works.
Injections and leakages can be influenced by monetary and fiscal policy, along with exchange rate manipulation. For example - lower interest rates reduce saving, and increase borrowing – and stimulate economic activity.
Lower exchange rates stimulate export sales, and put a break on imports - because lower exchange rates will make overseas goods more expensive. Understanding the circular flow is the starting point to understand the workings of the macro-economy.