The Circular Flow of Income shows how different units in an economy interact. It shows how household consumption is a firm’s income, which pays for labor and other factors of production, and how those firms provide households with income. The Circular Flow of Income demonstrates how Economists calculate national income or Gross Domestic Product.
Important Definitions for Circular Flow of Income
A. Household Sector
The household sector is made of people who have unlimited wants. The household sector is responsible for consumption and expenditure.
B. Firm Sector
The Firm Sector includes businesses and institutions that undertake 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.
C. Government Sector
Government spending is a large portion of the GDP. The government sector also passes laws and collects taxes.
Circular Flow of Income in Four Sector Economy
In the four sector economy, international trade is added. International trade includes exports and imports. The four sectors are household, firm, government and foreign. The arrows denote the flow of income through the units in the economy. This circular flow of income model also shows injections and leakages.
Injections are additions to the economy through government spending, money from exports and investments made by firms. Injections increase the flow of income.
- Investment (I). Money invested by firms in purchasing capital stock.
- Exports (X). Money coming from abroad to buy domestically produced goods.
- Government spending (G). Government welfare benefits, spending on infrastructure.
Withdrawals are leakages from the economy through taxes, spending on imports and savings. Withdrawals reduce the flow of income.
- Savings (S) (money not used to finance consumption, e.g. saved in a bank)
- Imports (M) (money sent abroad to buy foreign goods)
- Taxes (T) (money collected by the government, e.g. income tax and VAT)