Chapter 8
The Circular Flow Model
© 2003 South-Western College Publishing
Circular Flow of Income
Because land, labor and capital are
generally owned by households, firms
must pay for their use
 This payment along with profits become
income and purchasing power that can be
used to buy goods and services
 These payments are referred to as
resource income

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Circular Flow of Income



The demand for goods and services by the
recipients of resource income leads to more
output, which in turn brings about additional
payments of resource income
This cyclical operation of demand, output,
income, and new demand is illustrated by the
circular flow of income diagram
The size of the circular flow measures the level
of income and output in the economy
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Leakages
Resource income and spending are not
always equal because of
Leakages which flow out of the circular flow
that occur when resource income is received
and not spent directly on purchases from
domestic firms
Saving
Taxes
Import purchases
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Injections
However, at least some of these leakages
are returned to the circular flow via
various injections
Added spending into the circular flow that
are not paid out of resource income
Investment, government spending, and
exports bought by foreign buyers
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Circular Flow - Simple Model
Households offer their productive services to businesses in exchange for
pay in the form of wages, rent, and interest and owners receive profits
Resource Income
$$$
Productive Services
Businesses
Households
Income recipients use their money to buy
goods and services produced by business
Goods and Services
$$$
Spending for Goods and Services
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Stable Economy
If all income is spent
business will sell all goods, and
will be induced to produce all
goods again
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Stable Economy
Leakage in the circular flow
savings
Injection in the circular flow
investment
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Savings and Investment
If planned investment(I) = planned
savings(S)
so that injections = leakages
and total spending = total income
and demand = supply
then we have a stable economy
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Contracting Economy
If leakages exceed injections, we
have a contracting economy
resulting in
inventory accumulation
too little spending
drop in prices
and...Planned I < Planned S
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Expanding Economy
If injections are less than leakages, we
have an expanding economy resulting in
more goods and services produced
higher prices
and... Planned I > Planned
S
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Changes in Prices
 Whenever
leakages exceed
injections, it is also possible that the
market can be cleared in the price
level falls
 When injections exceed leakages,
increases in the price level will cause
the market to clear
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Equilibrium in the Circular Flow
Equilibrium
A stable flow of total output and
income
Planned I = planned S  injections =
leakages
Price level is stable
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Equilibrium in the Circular Flow
Planned I < planned S
Injections < leakages
Total income and output or the price level tend to
decrease
Income falls, saving decreases until it comes back
into balance with investment
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Equilibrium in the Circular Flow

Planned I > planned S
Injections > leakages
Total income and output tend to increase, if the
economy is at less than full employment  income
and saving increase until it comes into balance with
investment
If the economy is at full employment, the price level
tends to increase
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Government & Circular Flow
Balanced budget
amount spent by government = amount collected in
taxes
Surplus budget
amount spent by government = less than that
collected in taxes
Deficit budget
amount spent by government = more than that
collected in taxes
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International Trade & Circular Flow
Imports are a leakage
Exports are an injection
If exports = imports, the circular flow is in
balance
Usually it is not balanced
called a trade deficit, because imports (leakages) are
greater than exports (injections)
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Influences on the Circular Flow
Government budget
surpluses
deficits
International trade and finance
Asian financial crisis
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