Circular Flow of Income

In economics, the terms circ l r fl f i c or circ l r fl refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers.In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households. More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports.

Ass ti s e asic circ lar fl fi c e el c sists f seve ass ti s:  e ec y c sists f t sect rs: se l s a fir s. H se l s s e all f t eir i c e (Y) sa services r c s ti (C). ere is savi (S).
All t r

t t (O) r ce y fir s is t eir ex e it re (E).

rc ase

se

l s

 ere is fi a cial sect r. ver e t sect r.  ere is  ere is verseas sect r. It is a cl se ec y it ex

rts r i

rts.

Two Sector

odel

I t e si le two sector circular flow of income model t e state of eq ili ri is defi ed as a sit ation in which there is no tendency for the levels of income (Y), ex endit re (E) and out ut (O) to change, that is: Y=E=O This means that the ex enditure of uyers (households) ecomes income for sellers (firms). The firms then s end this income on factors of roduction such as la our, ca ital and raw materials, "transferring" their income to the factor owners. The factor owners s end this income on goods which leads to a circular flow of income.

Five sector model Table 1 All leakages and injections in five sector model

LEAKAGES

INJECTION

Saving (S)

Investment (I)

Taxes (T)

Government Spending (G)

Imports (M)

Exports (X)

The five sector model of the circular flow of income is a more realistic re resentation of the economy. Unli e the two sector model where there are six assumptions the five sector circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three more sectors introduced. The first is the Financial Sector that consists of anks and non- ank intermediaries who engage in the orrowing (savings from households) and lending of money. In terms of the circular flow of income model the leakage that financial institutions provide in the economy is the option for households to save their money. This is a leakage ecause the saved money can not e spent in the economy and thus is an idle asset that means not all output will e purchased. The injection that the financial sector provides into the economy is investment (I) into the usiness/firms sector.

The next sector introduced into the circular flow of income is the Government Sector that consists of the economic activities of local, state and federal governments. The leakage that the Government sector provides is through the collection of revenue through Taxes (T) that is provided y households and firms to the government. For this reason they are a leakage ecause it is a leakage out of the current income thus reducing the expenditure on current goods and services. The injection provided y the government sector is Government spending (G) that provides collective services and welfare payments to the community. An example of a tax collected y the government as a leakage is income tax and an injection into the economy can e when the government redistri utes this income in the form of welfare payments, that is a form of government spending ack into the economy.

The final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to an open economy. The main leakage from this sector are imports ( ), which represent spending y residents into the rest of the world. The main injection provided y this sector is the exports of goods and services which generate income for the exporters from overseas residents. An example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter of the wool (the farmer) therefore more money enters the economy thus making it an injection. Another example is China processing the wool into items such as coats and Australia importing the product y paying the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.