Last updated: Mar 13, 2021
The circular flow of income refers to the process by which spending in an economy creates income which in turn creates more spending. A country's national income is the value of all the economic activity generated through this income-expenditure process. Gross Domestic Product (or GDP) is the commonest measure of an economy’s national income and includes the output of all 'new' goods and services produced over a period of time – usually one year.
For an activity to be included in the measurement of national income it must add value. This means that not all transactions are included in the circular flow of income and in calculating national income. Gifts between family members, welfare transfers between the state and individuals, and the transfer of second-hand goods are not included in the measurement of national income. However, commissions and other income from selling second hand goods is included in the calculation of national income.
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, and use this income to pay for the factors they use.
In terms of the simple circular flow, income flows continuously backwards and forwards between households and firms as they engage in transactions, generating output and employment.
The smooth and continuous circular flow of income is disturbed as a result of income leaving the circular flow. Households are likely to save (S) some of their income (Y) which is a leakage out of the circular flow, and reduces expenditure and income - effectively making the economy smaller.
Households also pay taxes (T) to the government, which are another leakage, as is spending on imports (M) coming 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 (I) which is an injection into the circular flow.
Government spending (G) on merit goods and public goods is a further injection, along with overseas spending on a country’s exports (X).
The circular flow will be in a state of stable equilibrium when withdrawals are balanced by injections.
Withdrawals reduce the size of national income, while injections increase it. It is only necessary for the sum of injections to equal the sum of withdrawals - not for the ‘pairs’ to equal each other. Hence:
|S + T + M = I + G + X|
While it is not necessary for S to equal I, or G to equal T, or X to equal M, it is argued that, in the long term, any differences between the pairs of injections and withdrawals should be sustainable.
The circular flow can help understanding how economic policy works.
Injections and withdrawals 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.