The circular flow of expenditure and income is a
diagrammatic illustration of the flow of economic activities within an economy.
With it, we can explain the interaction of aggregate demand, national product
and national income within an economy. Aggregate demand is the total amount of
money consumers; business firms and the government are willing to spend on the
purchase of final goods and services. If we denote the expenditure of these
groups by C, I and G respectively then aggregate demand in an economy for a
given period (assuming there is no external trade) will be
diagrammatic illustration of the flow of economic activities within an economy.
With it, we can explain the interaction of aggregate demand, national product
and national income within an economy. Aggregate demand is the total amount of
money consumers; business firms and the government are willing to spend on the
purchase of final goods and services. If we denote the expenditure of these
groups by C, I and G respectively then aggregate demand in an economy for a
given period (assuming there is no external trade) will be
C + I + G
National product or output (which can be denoted
by Yo) is the form of goods and services produced in an economy within a
specified period. Hence, it defines the aggregate supply for the given time.
Finally, national income (denoted by Y) is the sum of the incomes of all the
individuals in the economy earned in the form of wages for labor, interest on
capital, rents on properties and profits on entrepreneurship. This is usually
calculated before any deductions are taken for income tax.
by Yo) is the form of goods and services produced in an economy within a
specified period. Hence, it defines the aggregate supply for the given time.
Finally, national income (denoted by Y) is the sum of the incomes of all the
individuals in the economy earned in the form of wages for labor, interest on
capital, rents on properties and profits on entrepreneurship. This is usually
calculated before any deductions are taken for income tax.
In order to understand the circular flow of
expenditure and income within an economy, we shall start with a very simple
assumption: the economy is made up of only two sectors, the household and the
business sectors. The household sector owns all the factors of production
(land, labor, capital and entrepreneurship) and sells its services to the
business sector, receiving factor incomes in return. The business sector, on
the other hand, converts these factor services into the production of goods and
services and proceeds to sell them back to the household sector. Now, if we
assume that the household sector spends all its income (i.e. personal savings
is zero), then, all the income paid to households by the business sector will
be received back by the sector in the form of consumption expenditures on the
goods and services produced.
expenditure and income within an economy, we shall start with a very simple
assumption: the economy is made up of only two sectors, the household and the
business sectors. The household sector owns all the factors of production
(land, labor, capital and entrepreneurship) and sells its services to the
business sector, receiving factor incomes in return. The business sector, on
the other hand, converts these factor services into the production of goods and
services and proceeds to sell them back to the household sector. Now, if we
assume that the household sector spends all its income (i.e. personal savings
is zero), then, all the income paid to households by the business sector will
be received back by the sector in the form of consumption expenditures on the
goods and services produced.
In the second round, the business sector engages
the services of households in the production process, paying income, which
again is expended on the goods and services produced. The income received by
the business sector from household’s expenditure on goods and services is again
available for a third round of investment and the circle continues ad-infinitum.
There are two important deductions we can make from this simple analysis.
First, there is a common identity between income received by the factors of
production within the economy, the output produced by the business sector and
the aggregate expenditure of households on goods and services. Since there are
no leakages out of the income flow, it is obvious that the values of these
three variables will be equal. In other words,
the services of households in the production process, paying income, which
again is expended on the goods and services produced. The income received by
the business sector from household’s expenditure on goods and services is again
available for a third round of investment and the circle continues ad-infinitum.
There are two important deductions we can make from this simple analysis.
First, there is a common identity between income received by the factors of
production within the economy, the output produced by the business sector and
the aggregate expenditure of households on goods and services. Since there are
no leakages out of the income flow, it is obvious that the values of these
three variables will be equal. In other words,
Output = Income = Expenditure
In our two-sector model. Secondly, if the
household sector were to save some of its income, it is obvious that the above
flow will be affected (since all of households’ incomes will not flow back to the
business sector in form of expenditures). Hence, savings constitute a leakage
out of the income stream. Leakages are expenditures that reduce the level of economic
activities (or the level of income) within the economy. Injections on the other
hand, are expenditures that increase the flow of income in the economy.
household sector were to save some of its income, it is obvious that the above
flow will be affected (since all of households’ incomes will not flow back to the
business sector in form of expenditures). Hence, savings constitute a leakage
out of the income stream. Leakages are expenditures that reduce the level of economic
activities (or the level of income) within the economy. Injections on the other
hand, are expenditures that increase the flow of income in the economy.
At the left side of the circle, we have the
household sector, which offers the service of productive factors to the
business sector (at the fight side). This movement is depicted in the outer
sphere of the lower part of the circular tube. In exchange, it receive incomes
(rent on land, wages on labor, interest on capital and profits on
entrepreneurship) denoted by R + W+ I + P (and represented in the inner sphere
of the lower part of circular tube). The business sector converts the
productive factors into goods and services, which are sold to the household
sector (outer sphere, upper part of circular tube). In return, the household
sector pays all its factor incomes back to the business sector as consumption
expenditures (inner sphere, upper part of circular tube). Hence, the lower part
of the circle tube constitute the factor market while the upper part explains
activities in the product market.
household sector, which offers the service of productive factors to the
business sector (at the fight side). This movement is depicted in the outer
sphere of the lower part of the circular tube. In exchange, it receive incomes
(rent on land, wages on labor, interest on capital and profits on
entrepreneurship) denoted by R + W+ I + P (and represented in the inner sphere
of the lower part of circular tube). The business sector converts the
productive factors into goods and services, which are sold to the household
sector (outer sphere, upper part of circular tube). In return, the household
sector pays all its factor incomes back to the business sector as consumption
expenditures (inner sphere, upper part of circular tube). Hence, the lower part
of the circle tube constitute the factor market while the upper part explains
activities in the product market.
Any income that is earned and received, but not
spent by households on consumption leaks out of the income stream as leakages
while injections are made into the stream when there is a fresh spending. A typical example of an injection is
investment expenditure by the business sector on goods and services including
real tangible assets like plant and equipment, financed by the savings of the
household sector. We can go beyond our two-sector model and include another sector:
the government sector. The government relates to both the business and the
household sectors by buying goods and services produced by the former and
employing the services of the latter.
spent by households on consumption leaks out of the income stream as leakages
while injections are made into the stream when there is a fresh spending. A typical example of an injection is
investment expenditure by the business sector on goods and services including
real tangible assets like plant and equipment, financed by the savings of the
household sector. We can go beyond our two-sector model and include another sector:
the government sector. The government relates to both the business and the
household sectors by buying goods and services produced by the former and
employing the services of the latter.
In return, it pays rents, wages, interests and
profits. In addition, government affects the household sector’s consumption
expenditures through taxes and transfer payments. Taxes take away from the
earned income of the households (reducing thereby their consumption) and thus
constitute a leakage out of the income stream. Transfer payments, on the other
hand, are those income received by households (from the government) which are
not earned in the current period. They include unemployment compensation, social
security benefits, pensions and other payments, which are not given for work
done in the current period. Finally, government competes with the business
sector for the limited savings of the households in order to finance its
expenditure (in excess of what it receives as taxes). Government expenditure,
like the investment expenditure of business firms, constitutes an injection
into the income stream. If we further enlarge the circular flow to include the
external sector, the concepts of exports and imports will come in.
profits. In addition, government affects the household sector’s consumption
expenditures through taxes and transfer payments. Taxes take away from the
earned income of the households (reducing thereby their consumption) and thus
constitute a leakage out of the income stream. Transfer payments, on the other
hand, are those income received by households (from the government) which are
not earned in the current period. They include unemployment compensation, social
security benefits, pensions and other payments, which are not given for work
done in the current period. Finally, government competes with the business
sector for the limited savings of the households in order to finance its
expenditure (in excess of what it receives as taxes). Government expenditure,
like the investment expenditure of business firms, constitutes an injection
into the income stream. If we further enlarge the circular flow to include the
external sector, the concepts of exports and imports will come in.
The introduction of the external sector will
change the circular flow since households can now purchase goods and services
from firms outside of the country (imports) and the business sector can also
sell goods and services to foreign households and governments (exports).
Exports thus constitute another injection (fresh income coming from abroad)
into the domestic income stream while imports constitute an additional leakage
out of the stream.
change the circular flow since households can now purchase goods and services
from firms outside of the country (imports) and the business sector can also
sell goods and services to foreign households and governments (exports).
Exports thus constitute another injection (fresh income coming from abroad)
into the domestic income stream while imports constitute an additional leakage
out of the stream.
The flow depicts a large circular tube flowing in
clockwise directions. There are several breaks in the tube, each break
representing a leakage or an injection. At point (1) on the circle, we find
consumers. Consumers receive disposable income (DI) (that is the sum of the
incomes of all the individuals in the economy after all taxes (TX) have been deducted
and transfer payments (TR) added), which is spent on consumption ©, which stays
in the circular flow, and savings (S), which leaks out of the flow. The leakage
into savings is channeled into the financial system, which converts them into
investment funds for firms.
clockwise directions. There are several breaks in the tube, each break
representing a leakage or an injection. At point (1) on the circle, we find
consumers. Consumers receive disposable income (DI) (that is the sum of the
incomes of all the individuals in the economy after all taxes (TX) have been deducted
and transfer payments (TR) added), which is spent on consumption ©, which stays
in the circular flow, and savings (S), which leaks out of the flow. The leakage
into savings is channeled into the financial system, which converts them into
investment funds for firms.
The upper loop of the circular flow represents
expenditures. As we move clockwise to point 2, we encounter the first injection
into the flow: investment spending (I). This is carried out by investors (which
may include both business firms and households). From point (2) upwards, the
flow is increasing with total spending moving up from C to C + I. with the
government demand for goods and services 9G) at point (3), aggregate demand
increase to C+ I +G. at point (4), aggregate demand for goods and service, i.e.
C + I + G arrives at the door of business firms. In response to this demand,
the firms produce national product. As
the circular flow emerges from the firms, it is renamed national income. The
lower half of the flow indicates how the income paid out by the firms at point
(4) moves to consumers at point (I), after some deductions are made by the
government through taxes (point 5). The government at this point also gives out
money as transfer payment. Once consumers receive the disposable national
income, we are back at point of the flow and the whole process is repeated.
expenditures. As we move clockwise to point 2, we encounter the first injection
into the flow: investment spending (I). This is carried out by investors (which
may include both business firms and households). From point (2) upwards, the
flow is increasing with total spending moving up from C to C + I. with the
government demand for goods and services 9G) at point (3), aggregate demand
increase to C+ I +G. at point (4), aggregate demand for goods and service, i.e.
C + I + G arrives at the door of business firms. In response to this demand,
the firms produce national product. As
the circular flow emerges from the firms, it is renamed national income. The
lower half of the flow indicates how the income paid out by the firms at point
(4) moves to consumers at point (I), after some deductions are made by the
government through taxes (point 5). The government at this point also gives out
money as transfer payment. Once consumers receive the disposable national
income, we are back at point of the flow and the whole process is repeated.