This article reviews the Keynesian model of the Circular Flow of Income (CFOI), National Income Equilibrium, Paradox of Thrift and The Multiplier Effect.
It explains the workings of two Circular Flow of Income (CFOI) models and what is meant by National Income Equilibrium.
You will also find here more information about the Paradox of Thrift, the importance of the Multiplier Effect for the economy and the limitations in the use of National Income statistics.
Circular Flow of Income (CFOI)
The Circular Flow of Income (CFOI) is a model showing the flow of goods, services and factors of production between economic agents within an economy.
These economic agents all make decisions which generate spending, output and income.
A. The 2 Sector Model of Circular Flow of Income (CFOI)
The 2 Sector Model of Circular Flow is sometimes called the Basic Model or the Closed Version. The two sectors include households (private citizens) and firms (private businesses).
Consumption happens when households spend their income on the output produced by firms. This output is produced using expenditure and resources from households.
B. The 5 Sector Model of Circular Flow of Income (CFOI)
The 5 Sector Model of Circular Flow of Income gives a more realistic view of the workings of an economy. It can also be called the Open Version because it includes all groups that are involved within the whole economy. In addition to households and firms, it also contains financial markets, the government and overseas markets.
Financial markets include banks and intermediaries who are involved in borrowing money, lending money and investments.
The government sector includes all local city-level governments, regional county-, state- or provincial-governments and the national central government. Overseas sector includes all business done with foreign countries in the form of imports and exports.
The 5 Sector Model of Circular Flow of Income is not only interested in exchanges between groups, but also so called ’leakages’ and ’injections’.
Leakages
Leakage means that money has left the system, like water leaking from a hole in a bathtub. Leakage can take the form of:
- Savings (S). Savings by households and other economic agents.
- TAXation (T). TAXation from government, e.g. Direct TAXes like income TAXes and Indirect TAXes on goods such as Value Added TAX (VAT).
- Imports (M). Imports from abroad means that the money leaves the domestic economy and enters another foreign economy.
Injections
Injections are when money is introduced to the economy, like water introduced to the bathtub. Injection means that money has entered the system and can come in the form of:
- Investment (I). Investment from the financial sector, e.g. capital investment such as a new factory in the form of a foreign investment.
- Government Spending (G). Government spending into building and developing communities, e.g. new hospitals, schools, motorways, new business initiatives and training schemes, etc.
- Exports (X). Exports abroad bring money into the system from buyers in foreign countries.
National Income Equilibrium
National Income Equilibrium occurs in the Circular Flow of Income (CFOI) when Total Leakages equal to Total Injections.
The formula for the equilibrium is as follows:
Savings + TAXes + Imports = Investment + Government Spending + Exports
Or:
S + T + M = I + G + X
Paradox of Thrift
Although households need to save some money, it is potentially harmful to the economy, if there is too much saving. Excessive saving reduces consumption, so firms will produce less.
There will be less investments too.
If firms are producing less goods than before, they will need less resources including raw materials and labour. The result is a fall in national income.
This is known as the Paradox of Thrift.
Multiplier Effect
John Maynard Keynes, the founder of Keynesian economics and the father of modern macroeconomics, stated that injections into the economy would increase national income more than the value of the injection itself. This is known as the Multiplier Effect.
For example, if investment is made into the economy by the government to build a new highway, many jobs are created. New jobs will lead to more people earning money and they will spend that money on further goods and services. Simply, the demand will drive the supply.
People will spend money on food, clothes, electronics, cars, holidays, etc. These industries would be experiencing higher demand, so they would employ more people who spend more money in the economy.
Again, this increases aggregate demand, so the cycle continues.
Accuracy of economic statistics
When economists and governments calculate economic growth, or economic recession, total national income is just an estimate.
The government has information, but with millions of figures to input regularly, it is difficult to maintain the accuracy of data. People transferring jobs, contractual or seasonal work also make the task difficult when trying to accurately compare the state of the economy on daily basis.
Additionally, any home-produced work is not included. This can include farming (you eat what you grow) and DIY (e.g. repairing/building your own house), as well as the hidden economy (black markets) where people avoid reporting their occupations.
Summary
The Circular Flow of Income (CFOI) shows how income is utilized within the economy. The Paradox of Thrift is a theory which says saving too much is damaging to the economy because people will consume less and companies will produce and invest less.
The Multiplier Effect states that national income will increase by an amount greater than the value of the injection itself multiplying the benefits for the country.
