Circular Flow of Income

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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).

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