The Circular Flow of Income and Spending

Written by Elin Thomas

The model of the circular flow of income and spending demonstrates the connections between different sectors of the economy.

• Shows the flows of goods and services and factors of production between firms and households.

• Shows how national income or GDP is calculated.

Payment for Goods and Services (Expenditure):

• Households spend the money they get from national income on the goods and services produced by firms - this makes up national expenditure.

Goods and Services:

• Firms produce goods and services - making up national output.

Factor Payment:

• Households (people who are consumers and owners of wealth) provide land, labor, and capital for firms. National income is the money firms pay households for these factors of production.

Factor Services:

• The services households provide to firms in order to allow them to produce goods and services.

Injections and Withdrawals:

Injections

Inflows of money into the economy that do not come from households:

• Exports - when goods and services from one country are bought by another, there is an introduction of money into the economy from the other country.

• Investment - expenditure on capital stock such as factories and machinery used to produce goods.

- Net investment: the value of the investment after you take into account the depreciation of goods.

- Gross investment: the total value of the investment not accounting for depreciation.

• Government Spending - when the government spends money in the economy such as building a new road it adds money to the circular flow by paying for the factors of production.

Withdrawals (Leakages)

Outflows of money from the economy which can come from firms or households:

• Imports - when consumers or businesses import goods they are spending in another economy which means money is leaving the circular flow.

• Savings - when consumers or businesses choose to save not spend it means there is less money in circulation as it is not being spent.

• Taxes - deducted from national income from consumers and businesses.

If injections and withdrawals are equal the economy is at equilibrium. If withdrawals are greater than injections then there is a reduction in national output and if injections are greater than withdrawals there will be an increase in output and the economy will grow.