The Circular Flow Model
The Circular Flow Model

Shows the economic transactions that
occur between households, firms and
other sectors in the economy.

Money flows- We will only focus money
flows as it is simpler than trying to account
for the physical flows.
The Circular Flow of Income and
Spending

The simplest form of circular flow
$ Consumption
Goods and Services
Producers
Households
Factors of production
(Land, Labour, Capital
Incomes $ rent wages interest profit
Introduction of the Financial Sector
Financial
Institutions
I (Investment)
d
Ca(Payments for goods
and services)
S (savings)
c
Producers
Households
b
Y (Income)
The financial Sector
• Households do not spend all the income they earn
they also save some.
• Savings = Income – Consumption
• Households usually save their income with banks.
• Banks then use this money to lend to firms.
• Firms then use these loans for investment (purchase
capital)
Interest
• When firms borrow from banks they pay interest in return for these
loans.
• Banks however, also pay interest to households for saving money with
them.
• BUT!
• Banks will charge a higher interest to borrowers than what they pay to
savers. This is how they make an income.
• E.g Joe saves 100 with BNZ and earns 5% interest in return for saving. BNZ then
loans some of this money out but charges 10% for loans.
Open Economy
Overseas
Sector
• Not all goods available in NZ are
produced in NZ.
Imports
– Imports = Goods made overseas but sold in
NZ
• Not all goods produced in NZ are sold
here.
Exports
– Exports = Goods made in NZ but sold
overseas
Producers
• Exports and Imports are real flows.
They are actual goods and services
being traded internationally.
Money Flows
– Export receipts= payments from
overseas firms to NZ firms for the
goods and services exported
overseas.
Overseas
Sector
Exports
Import
Payments
– Import Payments = NZ producers
payments to overseas firms for
the goods and services they have
Imports
imported.
– Remember export receipts are
coming into NZ
– Import payments are leaving NZ
Export
Receipts
Producers
An Open Economy
Financial
Institutions
Overseas
Sector
I (Investment)
d
X (Export
receipts)
f
M (Import
g
payments)
aC (consumption)
S (Savings)
c
Producers
Households
b
Y (Income)
Role of the Government
• The government collects taxes
– PAYE (pay as you earn) Income tax
– GST (goods and services tax) 15% tax on any good or service you consume.
– Company Tax – Taxes paid by producers to the government
• Transfers
– Subsidies that go to producers
– Social Welfare- (Sickness benefit, superannuation, unemployment benefit) this
flow goes straight to households.
• Government Spending
– Providing goods and services. (Schools, hospitals and the police force)
– Payment for goods and services
Role of the Government
Financial
Institutions
Overseas
Sector
I (Investment)
d
X (Export
receipts)
f
M (Import
g
payments)
aC (consumption)
S (Savings)
c
c
G (Government Spending)
Producers
Households
Government
tr
a
(transfers)
b
Y (Income)
T
b
(taxes)
The Circular Flow Model
Financial
Institutions
Overseas
Sector
d
I (Investment)
X (Export
e
receipts)
M (Import
f
payments)
aC (consumption)
S (Savings)
c
G (Government Spending)
i
Producer
Households
Government
tr
h
(transfers)
b
Y (Income)
T
g
(taxes)
The Circular Flow model









Y= Incomes including rent wages interest and profit
C= Consumption spending- the payment for goods and
services
S= Savings – income not spent on consumption this is a
withdrawal from the economy
I= Investment spending-purchase of capital goods. This is
an injection into the economy
X= Export receipts- Money received for exports sold
M= Import payments- Payments made for imports
purchased
G= Government Spending- on collective goods
T= Taxes the government collects from households and
firms. These are used to fund G and Tr.
Tr= Transfer money from one group to another, because of
this transfer payments are not true expenditure.
Withdrawals and Injections
• Withdrawal = A money flow that leaves the
circular flow
– I= Investment spending-purchase of capital goods. This is an
injection into the economy
– X= Export receipts- Money received for exports sold
– G= Government Spending- on collective goods
• Injection= Flows of money into the circular flow
model
– S= Savings – income not spent on consumption this is a
withdrawal from the economy
– M= Import payments- Payments made for imports purchased
– T= Taxes the government collects from households and firms.
These are used to fund G and Tr.
Money and Real Flows - Notes
• Money Flow – are the payments made for goods
purchased or the services being provided.
– E.g the payment of wages in return for the use of labour
• Real Flow – are the movements of actual goods
and services between different sectors of the
economy
– E.g. the use of labour by a producer