Modelling the economy

We are now going to start looking at a model of the way the economy works. This model can be regarded as a macroeconomic one as it focuses on the aggregate level of income and expenditure.

Z is a dressmaker in a small town in China. When Z spends 100 Chinese yuan at the local cafe, her expenditure becomes income for the cafe owner. The latter, in turn, will potentially spend a portion of this income on Z's dressmaking shop. This flow of income and expenditure, back and forth, in the economy is captured by the circular flow model. Let us now consider the model in some depth.

The circular flow of income model

The circular flow model focuses on two key aspects of the economy:

Income earned by households which is the reward for providing the services of factors of production to firms. For instance, individuals might work for firms or rent their buildings to firms.
Expenditure by households on the goods and services produced by firms. This constitutes the income for firms.

Assuming:

Firms do not retain any profits, that is, pay all their earnings as wages, rent, interest and profits to households
Households spend all they earn
There are only two sectors in the economy

The two flows must be equal.

Income received by households as wages, rent, interest and profits = Revenue received by firms as payment for goods and services sold to households

In the diagram below, the red arrows represent these monetary flows while the green arrows represent the corresponding goods and service rendered (provided) in return for those payments.

Circular flow in a two sector economy

This is the basic circular flow model where we assume that there are only two sectors in the economy. Let us now introduce some other sectors in our simple model and see how the circular flow might work.

Banks and the financial sector

So far, we have assumed that households spend all their income. In reality households often save for a 'rainy day' and firms retain a portion of their earnings to make Investments in order to expand their business.

When households save a part of their income they withhold a part of the circular flow from firms. These savings, therefore, act as a leakage or withdrawal from the circular flow. These savings can be held by households in banks and other financial institutions.

A leakage from the circular flow is the withdrawal of income by one group from the circular flow by not passing it to the other group. A leakage reduces the flow of income between households and firms.

Households are not the only group purchasing from firms. Firms might also purchase goods and services from other firms for the purposes of investment. This additional revenue for firms can be regarded as an injection into the circular flow. Firms might borrow the money for investment from banks and financial institutions.

An injection into the circular flow is income received by one group which does not arise from the spending of the other group. An injection expands the flow of income between households and firms.

Any injection or leakage can disturb the circular flow by increasing or decreasing the flow of income. An increase in savings will tend to reduce the overall circular flow while an increase in investment will increase the same.

Role of the government

Let us now expand the model and include a third key sector that plays an important role in the economy. This sector is the government which provides a number of services in the economy. In order to do so, the government also purchases goods and services and the services of factors of production. This government expenditure therefore acts as an injection expanding the circular flow including both the incomes received by households and the revenue received by firms.

On the other side, governments also collect taxes from their citizens in order to finance the goods and services they provide. These taxes may be collected from households or from firms. Either way, they act as a leakage from the circular flow thereby reducing the flow of income between households and firms.

Once again, injections and leakages disturb the equilibrium of the circular flow - increases in taxes can reduce the overall flow of income in the economy while an increase in government expenditure increases it.

Role of the foreign sector

"No man is an island!" and no modern economy is closed to influences from the rest of the world. In the current globalised environment there is a great deal of trade that takes place between countries. As a result, firms not only gain revenues from the expenditures by households (and firms) in their own country but also households and firms from other countries. This export revenue earned from the rest of the world acts as another injection into the circular flow. Likewise, domestic households also spend on goods and services produced by overseas firms. This import expenditure is a leakage from the circular flow of income.

Circular flow with leakages and injections

The diagram above shows the circular flow model with the leakages added in pink while the injections are shown in blue. The greater the aggregate leakages, the lower the circular flow. Similarly, the greater the injections, the higher the flow of income in the economy.

The circular flow model illustrates the interdependence between economic decision makers including households, firms, the government, the banks and financial sector, and the foreign sector (foreign firms and households). The economy is a complex web of interrelationships and transactions and the circular flow model provides a simplified representation of the flow of income between the various sectors in the economy.

Consider what might happen to the circular flow when the situations mentioned in the tiles below occur. Hover on the tile to check if your answer is correct.

Households' saving habits change and their tendency to save increases.

If households start saving more per unit of income, the circular flow will reduce as savings are a leakage from the flow.

Banks and financial Institutions ease their lending practices and start giving loans more easily.

If banks and financial institutions start lending more easily, investment by firms will increase and the circular flow will expand because investment is an injection.

The government reduces the taxes levied on firm and household incomes.

If the government reduces taxes, the circular flow will increase as the withdrawals decrease.

Incomes in trading partner countries increase encouraging them to spend more on exports

If incomes in a country's trading partners increases, their ability to spend on goods and services produced by other countries increases and export revenues for the domestic economy increase. The circular flow will therefore increase as injections increase.