The Circular Flow Model in Economics Explained with diagrams

Households consist of one or more persons who live in the same housing unit, such as a family. The economic resources are land, labor, capital, and entrepreneurial ability. Yes, exports add to the circular flow of income by bringing in additional income from foreign markets. Foreign consumers and firms will, however, also wish to buy domestic products, called exports (X), and this is an injection into the circular flow.

A positive current account means that net exports plus net income flows from the rest of the world are positive. In this case, our economy is lending to the rest of the world and acquiring more assets. There are flows of goods and labor services that correspond to the flows of pesos shown in Figure 18.11 “The Simplest Version of the Circular Flow”. Three hundred billion pesos worth of pizza flows from firms to households, and 300 billion pesos worth of labor services flow from explain circular flow of national income with five sector model households to firms. Withdrawals are leakages from the economy as a result of taxation, spending on imports, and monetary savings. The circular flow will adjust following new injections into it or new withdrawals (aka leakages) from it.

In order tocomplete the basic model, we need to account for the saving and investmentflows of households and businesses, the actions of government, and the natureof foreign trade. I will do this shortly, but first let’s briefly discuss theflows between households and businesses in a little more depth. Leakages in the circular flow of income are the economic activities that remove money from the circulation within an economy, causing a reduction in the overall flow of income. The primary types of leakages include savings (S), taxes (T), and imports (M). The firm sector includes businesses that take on the risk of combining scarce resources to produce goods and services. This sector buys capital goods with investment and pays for the factors of production.

Phases of Circular Flow of Income

This equation is called the national income identity and is the most fundamental relationship in the national accounts. Government injects income back into the economy by spending (G) on public and merit goods like defence and policing, education, and healthcare, and also on support for the poor and those unable to work. This insight from the circular flow is a starting point for explaining what happened in Argentina and what happens in other countries when output decreases.

Luckily, economists have developed models to help us learn and understand how the economy functions. The CircularFlow Model is one of the most basic models in macroeconomics, and it cannot provideanything close to a full overview of all the machinations in a complex real-worldeconomy. All economic models are abstractions that serve to highlight somebasic features of reality, and this model is no exception. All people are consumersand all expenditure is done to maximize consumption i.e., to gain the maximum utility from thegoods and services that their incomes can afford.

Definitions of Injections & Withdrawals

1. That is the basic form of the model, but actual money flows are more complicated.
2. Savings (S) by businesses that otherwise would have been put to use are a decrease in the circular flow of an economy’s income.
3. These dollars are then used to deploy capital projects or public programming, both of which may benefit Apple, its employees, or its customers.
4. In each firm, and thus in the firm sector as a whole, revenues must equal payments to inputs.
5. The income distribution starts with households, as they provide factors of production to businesses, and then businesses pay rewards for factors of production (factor income) to the households.

From the government’s perspective, both households and business pay taxes. These dollars are then used to deploy capital projects or public programming, both of which may benefit Apple, its employees, or its customers. If businesses decided to produce less, it would lead to a reduction in household spending and cause a decrease in GDP. Or, if households decided to spend less, it would lead to a reduction in business production, also causing a decrease in GDP. In the circular flow graphic, individuals both receive and spend money. In Figure 31.21, this equation corresponds to the fact that the flows into and from the household sector must balance.

Four-Sector Model: Incorporating Foreign Trade

Exports (X) are the value of the goods and services sold by the people of a country to the foreign sector. The money earned from exports is an injection and is an activity of the foreign sector. Net exports (NX) is the difference between the value of exports and the value of imports.