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
In summary, The Circular Flow of Income (CFOI) shows how income is utilized within the economy.
