The circular flow shows how income and spending move round an economy. Households own the factors of production (land, labour, capital and enterprise) and sell their services to firms; firms use them to make goods and services, which households buy.
- Real flows are the things themselves: factor services go from households to firms, and goods and services go from firms to households.
- Money flows go the other way round: firms pay households income (wages, rent, interest and profit), and households spend it on firms' goods and services.
- Withdrawals (W), or leakages, are income that is not spent on the country's own output: saving (S), taxation (T) and spending on imports (M).
- Injections (J) are spending on the country's output that doesn't come from households' own income: investment (I) by firms, government spending (G) and exports (X).
How to read it. Choose two, three or four sectors in the title bar: the government (T and G) and then the rest of the world (M and X) join the diagram. The financial sector (S and I) can be switched on or off. Show the money flows, the real flows or both, in their own colours. The width of each arrow shows the size of the flow.
The sliders. Injections are amounts ($bn a year). Withdrawals are shares of income: households save, pay tax on and import a fixed percentage of whatever they earn, so withdrawals grow as income grows.
Round by round. Each round, households receive the national income, withdraw their share, and spend the rest with domestic firms. Firms receive that spending plus the injections, and pay it out as the next round's income.
- If J > W, more spending enters the flow than leaks out, so national income rises. As it rises, withdrawals rise with it, until they match injections.
- If J < W, more leaks out than enters, so national income falls, until withdrawals have fallen to match injections.
- National income is in equilibrium (stable) when J = W, that is, when I + G + X = S + T + M.
Notice that national income changes by more than the change in injections: extra spending becomes someone's income, and part of it is spent again in the next round.
Common exam mistakes
- Drawing the real and money flows in the same direction: they go in opposite directions round the circle.
- Calling taxation an injection or exports a withdrawal. Taxes and imports take spending out; government spending and exports put it in.
- Saying that saving must equal investment (or T = G, or X = M) in equilibrium. Only the totals must balance: J = W.
- Treating households' consumption as an injection. It is part of the circular flow itself.
- Saying income keeps rising for ever after an injection. It stops rising once withdrawals have caught up.
Objective: describe the circular flow of income between households and firms, and explain how injections and withdrawals change national income until it reaches equilibrium where J = W (Cambridge IGCSE Economics 0455: the macroeconomy; Cambridge International AS Level Economics 9708: the circular flow of income).
Where this fits
- AP: AP Macroeconomics
- AQA: AQA A Level Economics (7136)
- Cambridge: Cambridge A Level Economics (9708); Cambridge AS Level Economics (9708) Goes beyond Cambridge AS Level Economics (9708): The round-by-round move to J = W is the A Level multiplier process (9.1); AS needs only injections, leakages and equilibrium.
- IB: IB Economics HL; IB Economics SL
- NCEA Level 1 Commerce: 92030 Demonstrate understanding of how entities with interdependent financial relationships are affected by an event; 92030 Demonstrate understanding of how entities with interdependent financial relationships are affected by an event; 92030 Demonstrate understanding of how entities with interdependent financial relationships are affected by an event
- NCEA Level 2 Economics: 91224 Analyse economic growth using economic concepts and models
- NCEA Level 3 Economics: 91403 Demonstrate understanding of macro-economic influences on the New Zealand economy
- Pearson Edexcel International: Edexcel International A Level Economics
- USDP: USDP Economics
