What this lesson teaches
I can describe the circular flow of income between households, firms, the government and the foreign sector.
Syllabus 9570, 3.1.1(a). Circular Flow of Income: The circular flow of income as an interactive model involving households, firms, government and the foreign sector
Make a guess
A household earns $1,000 and saves $200 of it. Is that saving lost to the economy for good?
- Not if banks lend it to firms that invest.
- No, because savings are counted as consumption.
- Yes. Saved money leaves the circular flow forever.
Show the answer
Not if banks lend it to firms that invest.
Saving is a withdrawal from the circular flow, but investment is an injection. If the savings fund new machines, the money flows back in.
Spending by one group is income for another; injections add to the flow and withdrawals drain it.
The circular flow shows money moving around the economy. Households supply labour to firms and receive income. They spend it on firms' goods, which becomes firms' revenue, which pays more incomes.
Some income leaks out of this loop. These withdrawals are saving (S), taxes (T) and spending on imports (M).
Some spending enters the loop from outside it. These injections are investment (I), government spending (G) and exports (X).
If injections are greater than withdrawals, national income rises. If withdrawals are greater, it falls. National income is in equilibrium when I + G + X = S + T + M.
- Injections
- I, G, X.
- Withdrawals
- S, T, M.
- Equilibrium
- I + G + X = S + T + M.
Worked example: Where a household's $1,000 goes
A household earns $1,000 this month. It spends $600 on local goods, $100 on imports, saves $200 and pays $100 in tax.
- Only the $600 spent on local goods flows straight back to local firms.
- The $100 on imports, $200 saved and $100 in tax are withdrawals: $400 in total.
- If a firm borrows savings to buy new local equipment, that investment is an injection that brings money back into the flow.
- Whether income grows depends on total injections compared with total withdrawals.
Watch out for this
Saving is always bad for the economy because it leaks out of the circular flow.
Saving is a withdrawal, but banks can lend it to firms for investment, which is an injection. Saving is only a problem if it is not matched by injections.
Check your understanding
Which of these is an injection into the circular flow?
- Exports.
- Imports.
- Saving.
Show the answer
Exports.
Right. Foreign spending on local goods adds money to the flow.