Circular Flow of Income

certified ManagementGoeroes expert badge
5 mins read

The Circular Flow of Income model is a macro-economic model that can be used to explain how money is distributed within an economy. The model takes into account six factors that influence cash flows within an economy.

Simplest form of the Circular Flow of Income model

The simplest model of the circular flow of income takes into account only two factors:

  1. households (consumers) and
  2. businesses

This is the model for a closed economy. Households have the means of production. Means of production (or production factors) are: Land (also referred to as nature), labor and capital. Companies use the means of production to produce goods and services. The households receive money in exchange for the means of production. Rent for land, wages for labor and interest or dividend for money. On the other hand, households purchase the goods and services from the companies, for which they pay the companies. On the one hand, money flows around, on the other hand, there is a flow of goods and services. So the circle is round.

The detailed explanation of the Circular Flow of Income

In practice this is of course not that simple. Indeed, there are other factors that cause money to flow (leaks) out of the closed economy as discussed above, and there are factors that cause money to flow into the economy (injections).

Injections (money flows in the economy): Leaks (money flows from the economy)
- Government spending - Taxes
- Export - Import
- Investments - Savings

Public spending, export, and investments are the three factors that drive more money into an economy. On the other hand, money is 'leaking' from the economy because money is being spent to import goods or services from abroad, to pay taxes and because savings are being made.

Circular flow of income model

All factors from the Circular Flow of Income - including example:

  • Income (Y) - Wages, dividends & interest that go from businesses and financial institutions to households.
  • Savings (S) - Savings from consumers, companies or the government that flows to financial institutions.
  • Expenditure (E) - Consumer spending, money that flows from households to businesses.
  • Taxation (T) - Taxes that go to the government from households and businesses.
  • Investments (I) - Investments (loans) from financial institutions in business, to consumers or the government.
  • Government spending (G) - Government spending on businesses in the form of contracts or towards households in the form of wages for civil servants or, for example, benefits.
  • Import (M) - Expenditure of companies, government and consumers abroad (money flows from the economy).
  • Export (X) - Income from the sale of goods and services abroad (money flows into the economy).

What do you use the Circular Flow of Income model for?

There are different ways to attract money. Financial institutions can raise their interest rates, the government can take tax measures (raise or lower the tax), the business community can raise the interest on its bonds. You can borrow money from financial institutions etc. Another possibility is to limit your expenses. So the government can reduce government spending. Consumers can keep their household expenses low, or companies can lay off staff, which means they have fewer costs. All these measures have an effect on the circular flow of income. Via the circular flow of income, you can determine what effect certain trends can have on an economy. For example, if exports (X) drops, this means that the business world earns less money. They can try to withdraw this money from the bank by requesting (borrowing) an investment (I). The bank will have to top up its assets, for example with savings. You raise savings by increasing the interest. Because the companies have less income, the government has less income from taxes. The government can choose to raise taxes or limit government spending.

Calculations from the Circular Flow of Income

The circular flow of income model is based on the comparison S + T + M = I + G + X. The total savings of households + the total tax revenue of the government + the total income from exports = always equal to the total expenditure of the financial sector (loans) + Total government spending + spending on imports. All goods and services produced by companies is the gross national product (GNP)

All the money that enters the households from the production factors that they own is called the gross national income (GNI).

Article rating: 1.4 (21 reviews)
Share this article

Related articles

Popular articles

Show more


Mohamed Shaalan
Mohamed Shaalan
$ 1.60 PM
I'm the ONE YouTube Consultant ★ YouTube Certified Expert
show profile
YouTube Consultant
Qesm Bab Sharqi ,  Egypt
Languages: Arabic, English
consultant online marketing advice social media management content marketing growth strategy growth hacking social media marketing digital marketing advertisement youtube videos social media ads adwords content strategy
Mohamed is available
but not online right now
Callback request
Robel  G Michael
Robel G Michael
$ 0.28 PM
I'm the ONE that offers customised and personalised consultancy. NO SOP
show profile
Vienna ,  Austria
Languages: Dutch, English, Italian, German
consultancy business development relationships financial advice startups dutch italian amharic event cooking
Robel is available now
Call me
Ilkyu Lee
Ilkyu Lee
$ 0.93 PM
I'm the ONE I am the man who is kind, generous, diligent, and flexible person as I believe.
show profile
Queens County ,  United States
Languages: English, Korean
consultant business new york city computer basic knowledge
Ilkyu will be available in 3 hours 39 mins
Call anyway
Barath Pandi
Barath Pandi
$ 0.13 PM
I'm the ONE Doctorate in Mechanical and Energy Engineering specialized in Innovations!!!!
show profile
R & D Engineer
Metropolitan City of Milan ,  Italy
Languages: English, Italian
energy business consultancy automotive milano office 365 c++ coding mechanical works engineering design kids crafts french course indian cuisine italian food presentation expert
Barath is available
but not online right now
Callback request
Jasper Mckeag
Jasper Mckeag
$ 0.28 PM
I'm the ONE Straight to the point. Constructive criticism is essential, a short call?
show profile
Exercise & Music
Greater Manchester ,  United Kingdom
Languages: English, Italian
consultant tourism hospitality business objectives mixing dj techno house smoking party trance house music clubbing drinking advice
Jasper is available now
Ring me