The Circular Flow Of Income Economics Essay

The circular flow of income is a macroeconomic model that was most prominently used by the classical economists in the post-great war era. It is used to describe the give-and-take nature of the circulation of income between consumers (or households) and producers (or firms)1. The model is particularly good if used to describe a closed economy where there is no trade outside of domestic markets. The circular flow has both an inner and an outer flow, I will concentrate now on the inner flow:

HOUSEHOLDS

The above diagram is the inner flow of the circular flow of income. It is assumed in this model that there are two key institutions in an economy which are firms and households, that all income is used within the inner flow between the two institutions and that there is no government intervention and there is no banking sector. Firms create domestically produced goods and services, they sell these to households, and it is a major source of their income. However to do this they need factors of production such as land, labour and capital. Households require, in a closed economy, need domestically produced goods and services produced by firms, but they come at a cost. This problem is easily solved through a trade-off, households own factors of production, whether that labour, land or capital, firms use what is called factor payments (which is the income received for providing factors of production) as remuneration for providing the factors of production. All the income received from factor payment is then assumed to be spent on consumption of domestically produced goods and services (Cd), which then firms spend on factor payments, resulting in an interminable loop. This displays the interdependence of the two institutions, one cannot survive without the other, and they are two of the most fundamental elements of a developed economy to this day. The model is at this point considered be in equilibrium. Equilibrium in the circular flow occurs when there is a balance between the institutions, and here there always is, as long as all households spend on domestic goods and services and all firms spend on factor payments

FIRM

HOUSEHOLD

The inner flow is only a one section of the entire circular flow of income, as it is not realistic to have such strict assumptions in the real world. In the full circular flow of income model, the assumptions are significantly relaxed, which opens the doors too withdrawals out of the inner flow and injections which into the inner flow. We will now assume that there are 5 institutions in the economy, Household and Firms remain, but in addition there is now a financial institutions, as well as a government and trade with other nation states. Also we assume that some income isn’t spent on the consumption of domestically produced goods and services, some of it is used by households to save in banks, to pay takes and to indulge in imports (the circular flow is now no longer a closed economy). This is the flow in its complete form:2

As you can see in blue, the inner flow remains the same with households and firms, however now there are red arrows representing withdrawals (W), green lines representing injections (J) and more institutions acting as facilitator of these actions the additions to the model can be called the outer flow. Injections happen when income is put into the flow from outside the inner flow, this can occur when banks act as an intermediary between savers and borrowers, firms can loan from bank to spend on investment in there company. Another would be if the governments used their income on goods produced by firms, meaning money from outside the inner flow is pumped in as an injection. Also when other nation states spend money on goods produced by the firms, the export expenditure is acts as an injection too.

A withdrawal occurs when money leaves the inner flow. In this model a withdrawal can take place in many ways. When a household saves/borrows money in a financial institution such as a bank net savings (which is savings — borrowings) is the withdrawal, it can be negative if borrowing exceeds savings. This is similar to net taxes, taxes paid to the government (i.e. council tax or VAT) are a withdrawal but governments also give out transfer payments (which is income given from one to another without any productive process, in the UK benefits are the most obvious example) so net taxes (taxes paid — transfer payments) could also be negative if transfer payments exceeds tax payment. The final withdrawal is when they a household buys imported goods, as money leaves the inner flow and goes abroad.

As this model is more realistic, to achieve a state of equilibrium similar to that of the inner flow model, you must first realise a point where injections are equal to withdrawals.