The Circular Flow of Income

The Circular Flow of Income

• The circular flow of income is a model that seeks to explain how the economy works and how changes in AD occur
  • There are two ‘sectors’ – Households and Firms
  • Between these two are the ‘flows’ – income, products, and factor services
  • Households provide factor services and receive factor incomes
  • The factor incomes are then used to buy products produced by firms

• In practise, not all the income that is earned is spent, as there are additional forms of spending that do not arise in the circular flow
  • There are three ‘leakages’: Taxes (T), Saving (S), and Spending on Imports (M)
  • Leakages reduce AD
• Injections, on the other hand, increase AD
  • These are: Investment (I), Government Spending (G), and exports (X)
• Then the value of injections = the value of leakages, there will be no change in output and hence, macroeconomic equilibrium