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Chapter 4
The Circular Flow
Model
© 2001 South-Western College Publishing
Circular Flow of Income
 The cyclical operation of demand, output,
income, and new demand
– Leakages: flows out of circular flow
when resource income is received and
not spend directly on purchases from
domestic firms
– Injections: Added spending in circular
flow that does not come out of current
resource income
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Circular Flow - Simple Model
Resource Income
$$$
Productive Services
Businesses
Households
Goods and Services
$$$
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 are Higher than 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 Higher 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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Summary of
Circular-Flow Model
 Planned I = Planned S (injections=leakages)
 Planned I < Planned S (injections< leakages)
 Planned I > Planned S (injections>leakages)
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Government and the
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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The Three Assumptions
1. Households always pay taxes out of
current incomes.
2. If households did not pay taxes, they
would spend the money on consumption
or investment.
3. The government borrows from banks
instead of from individuals and firms.
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International Trade and the 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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