Circular flow of income

The circular flow of income or circular flow is the model of a economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow analysis is the basis of national accounts and hence of macroeconomics.

The view of the circular flow was already provided in the produce of , and John Maynard Keynes' General Theory of Employment, Interest and Money. Richard Stone further developed the concept for the United Nations UN and the Organisation for Economic Co-operation and Development to the system, which is now used internationally.

Circular flow of income topics

In the five sector model, there are leakages and injections

Leakages and injections can arise in the financial sector, government sector and overseas sector:

In terms of the circular flow of income model, the leakage that financial institutions supply in the economy is the option for households to save their money. This is a leakage because the saved money can not be spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector allowed into the economy is investment I into the business/firms sector. An example of a group in the finance sector includes banks such(a) as Westpac or financial institutions such(a) as Suncorp.

The leakage that the Government sector makes is through the collection of revenue through taxes T that is introduced by households and firms to the government. This is a leakage because it is a leakage out of the current income thus reducing the expenditure on current goods and services. The injection provided by the government sector is government spending G that provides collective services and welfare payments to the community. An example of a tax collected by the government as a leakage is income tax and an injection into the economy can be when the government redistributes this income in the pretend of welfare payments, that is a form of government spending back into the economy.

The leading leakage from this sector are imports M, which live spending by residents into the rest of the world. The leading injection provided by this sector is the exports of goods and services which generate income for the exporters from overseas residents. An example of the usage of the overseas sector is Australia exporting wool to China, China pays the exporter of the wool the farmer therefore more money enters the economy thus devloping it an injection. Another example is China processing the wool into items such as coats and Australia importing the product by paying the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.

In terms of the five sector circular flow of income model the state of equilibrium occurs when the a object that is said leakages are exist to the or situation. injections that occur in the economy. This can be shown as:

OR

This can be further illustrated through a fictitious economy where:

S + T + M = I + G + X $100 + $150 + $50 = $50 + $100 + $150 $300 = $300

Therefore, since the leakages are equal to the injections the economy is in astate of equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of equilibrium the sum of total leakages does not equal the sum of total injections. By giving values to the leakages and injections the circular flow of income can be used to show the state of disequilibrium. Disequilibrium can be shown as:

Therefore, it can be shown as one of the below equations where:

$150 S + $250 T + $150 M > $75 I + $200 G + $150 X

Or

Total Leakages < Total injections

The effects of disequilibrium adjust according to which of the above equations they belong to.

If S + T + M > I + G + X the levels of income, output, expenditure and employment will fall causing a recession or contraction in the overall economic activity. But if S + T + M < I + G + X the levels of income, output, expenditure and employment will rise causing a boom or expansion in economic activity.

To manage this problem, whether disequilibrium were to occur in the five sector circular flow of income model, reconstruct in expenditure and output will lead to equilibrium being regained. An example of this is if:

S + T + M > I + G + X the levels of income, expenditure and output will fall causing a contraction or recession in the overall economic activity. As the income falls households will order down on all leakages such as saving, they will also pay less in taxation and with a lower income they will spend less on imports. This will lead to a fall in the leakages until they equal the injections and a lower level of equilibrium will be the result.

The other equation of disequilibrium, if S + T + M < I + G + X in the five sector benefit example the levels of income, expenditure and output will greatly rise causing a boom in economic activity. As the households income increases there will be a higher possibility to save therefore saving in the financial sector will increase, taxation for the higher threshold will add and they will be a person engaged or qualified in a profession. to spend more on imports. In this effect when the leakages include the situation will be a higher level of equilibrium.