The circular flow of income model (VCE Economics Unit 3)

What this dot point is asking

VCAA wants you to describe the circular flow model, identify the sectors and flows, define leakages and injections, explain what equilibrium means in the model, and explain how a change in leakages or injections changes the level of economic activity. Expect short-response and 4 to 8 mark extended responses, often requiring a labelled circular flow diagram.

The answer

The circular flow model

The circular flow of income is a simplified model of how income, expenditure and output move between the sectors of the economy. It shows that one agent's spending is another agent's income, so the flows circulate continuously.

The five sectors

1. Households. Own the factors of production (land, labour, capital, enterprise) and supply them to firms. They receive factor income (wages, rent, interest, profit) and spend it on goods and services.
2. Firms (businesses). Use factors of production to produce goods and services. They pay factor income to households and receive consumption expenditure.
3. The financial sector. Channels household saving (a leakage) into business investment (an injection).
4. The government sector. Collects tax (a leakage) and spends on goods, services and transfers (an injection).
5. The overseas sector. Receives spending on imports (a leakage) and pays for Australian exports (an injection).

The two key flows

• The real flow. Factors of production flow from households to firms; goods and services flow from firms to households.
• The money flow. Factor income flows from firms to households; consumption expenditure flows from households to firms.

The two flows move in opposite directions around the model.

Leakages and injections

Leakages are withdrawals from the circular flow (income not passed straight back to domestic firms as spending):

• Savings (S). Household income put aside rather than spent.
• Taxation (T). Income taken by government.
• Imports (M). Spending that flows overseas rather than to domestic firms.

Injections are additions to the circular flow (spending that does not come from current household consumption):

• Investment (I). Business spending on capital.
• Government spending (G). Public spending on goods and services.
• Exports (X). Overseas spending on Australian production.

Equilibrium in the model

The economy is in equilibrium when total leakages equal total injections:

At equilibrium, the level of economic activity (real GDP) is stable: the income flowing out as leakages is exactly replaced by injections, so output, income and expenditure stay constant.

Disequilibrium and changes in activity

When leakages and injections are not equal, the level of activity changes.

• Injections greater than leakages ($I + G + X > S + T + M$). More is being added to the flow than is withdrawn, so expenditure and output rise. Firms produce more, hire more workers and pay out more income. Real GDP rises and unemployment tends to fall. This is an expansion.
• Leakages greater than injections ($S + T + M > I + G + X$). More is withdrawn than added, so expenditure and output fall. Firms cut production and employment. Real GDP falls and unemployment tends to rise. This is a contraction.

In each case, the change in income itself changes leakages until balance is restored at a new, higher or lower level of activity.

The multiplier

A change in an injection has a magnified effect on national income because spending recirculates. When a firm invests, it pays incomes that households then spend, generating further income, and so on. Each round is smaller because part of the income leaks out as saving, tax and imports. The total rise in GDP is a multiple of the initial injection. The larger the leakages, the smaller the multiplier.

Link to aggregate demand

The injections map onto the components of aggregate demand: $AD = C + I + G + (X - M)$. A rise in injections (or a fall in leakages) raises AD, which raises real GDP in the short run. This is why monetary and budgetary policy work through the circular flow: they change injections (government spending) and leakages (taxation) or influence private injections and leakages (investment, saving) via interest rates.

Examples in context

Example 1. COVID-19 stimulus as an injection

In 2020 the federal government dramatically increased government spending (G) through JobKeeper and the JobSeeker supplement, while the RBA cut rates to lift investment (I). These injections offset the collapse in private spending and the rise in saving (a leakage) as households hunkered down, helping support the level of economic activity during the pandemic.

Example 2. Import leakage and the multiplier

When Australian households spend on imported goods, that spending leaks overseas rather than circulating domestically. A high import propensity reduces the size of the domestic multiplier, which is one reason stimulus directed at locally produced services tends to have a larger effect on domestic activity than stimulus that flows quickly into imports.

Example 3. A mining investment surge

During the resources boom, a large rise in business investment (an injection) raised incomes and employment well beyond the mining sector itself, as construction, services and household spending recirculated the income. Check ABS National Accounts for the latest components of GDP.

Try this

Q1. List the three leakages and the three injections in the circular flow model. [2 marks]

• Cue. Leakages: savings, taxation, imports. Injections: investment, government spending, exports.

Q2. State the condition for equilibrium in the circular flow model. [2 marks]

• Cue. Total leakages equal total injections: S + T + M = I + G + X.

Q3. Using the circular flow model, explain how a rise in household saving (with injections unchanged) would affect the level of economic activity. [4 marks]

• Cue. Saving is a leakage; higher saving means leakages exceed injections, so expenditure and output fall. Firms cut production and employment, real GDP falls, and the effect is magnified by the multiplier until a new, lower equilibrium is reached. This is the "paradox of thrift".