“All You Need To Know About The Circular Flow Of Income”

Circular Flow of Income

On any given day post-work, we waltz into groceries, grab items needed, pay for them and head home. We then follow up our nighttime routine and wake up timely the following morning to go back to work. In general, this is certainly a common flow of event for most of us. While we understand the most expected reason to work is to earn money and purchase needs but what we probably don’t give much attention to is how this earning-purchasing cycle affects the economy. In other words, what is this circular flow of income and how it works?

For beginners, a circular flow of income reflects how money travels through an economy. In precision, it shows how money moves through businesses and individuals. For better understanding, let’s take a glimpse at some of its key terms.

The Circular Flow of Income

Key terms of Circular flow of income

"circular flow of income- basics"
Source: Wikipedia

Households/Individuals: This describes the consumers. For example, these are the people who earn and then spend money on the necessities.

Firms/Businesses: This describes the producers. For example, the business and companies who produce goods and services for the households to buy.

Factors: This describes the input materials required to produce goods. These are of three types namely, capital, labor and land, enterprise profit. For example, firms use capital to run their business, individuals from households work and provide labor then the former can use the land to build factories and manufacture products.

Expenditure: This describes the money that moves through the economy. For example, other above-mentioned key terms use the money to purchase goods and services from the firms.


So, let’s interlink all the four key terms altogether. Firstly, households go to work and earn money which is called income. Secondly, they use this income to purchase goods from firms. Next, the firm use factors from households like labor and land for better productivity. Then, the firms use these factors for goods manufacturing that households buy at the cost of their expenditure. Hence, from the entire cycle, we analyzed that money from individuals’ purchases becomes the income of the businesses. Likewise, the money of the business through salaries paid and goods produced becomes the income of the individuals.

However, this is the basic form of the model, but actual money flows are more complex than this. Economists have consequently added in more factors to better depict complex modern economies. These factors are the precursors of the nation’s GDP or national income, as a result, it’s called the circular flow of income.

Moreover, the modern flow is expanding its sector far more than those consumers and businesses. Two more sectors have also been included in the circular flow of income, the government sector and the foreign trade sector. The government injects money into the circle through government spending on programs, for example, Social Security and National Parks Administration. Then, the money also flows into it through exports, bringing cash from foreign buyers.

Outflows of cash

Source: Wikipedia

Source: Quora

Just as money is injected into the economy, it’s simultaneously withdrawn through various means. For these means, Government firstly imposes taxes to reduce the flow of income. Secondly, money accredited to foreign companies for imports also constitutes a leakage. Furthermore, businesses segregate some part of their income as savings, which decrease the overall flow of the economy’s income.

✓Important: GDP is calculated as consumer spending plus government spending plus business investment plus the sum of exports minus imports.

Importance of Circular Flow of Income

Key terms of the circular flow of income
Source: SlideShare

1. Link between producers and consumers

It establishes a link between producers and consumers. Producers buy the services of production via money with which the latter, in turn, purchase goods from the producers. Thus, it creates a network of markets for different goods and services where all sale and purchase-related problems are automatically solved.

2. Inflationary and Deflationary Tendencies

Various leakages or injections in the flow disturbs the smooth ongoing economy. For instance, Saving is a leakage out of the expenditure stream. If saving increases, it’ll depreciate the income flow. As a result, it reduces employment, income and prices, thereby leading to a deflationary process in the economy.

However, to counter-cut this, some inflationary tendencies such as consumption expenditure and investments, are used.

3. Importance of Monetary Policy

The equality of saving and investment is certainly a highlighting factor here which deals with the capital market. The latter is controlled by the Government’s monetary policy.

When saving exceeds investment or vice versa, it leads to deflation or inflation respectively. So, it’s through the monetary policy that investment is encouraged or retarded.

4. Importance of fiscal and trade policies

It also points towards the importance of fiscal and trade policies. For the circular flow of money to be in equilibrium, saving plus taxes (S+T) must equal investment plus government expenditure (I+G).

Similarly, imports are leakages in the circular flow of money because they’re foreign payments. To stop this, Government is consequently adopting measures leading to minimum imports and maximum exports.

5. Some other advantages also include multiplier and flow of fund accounts.

To sum up

So, this was all about the complete guideline for the Circular Flow of Income and its importance. Hope you found it useful, also don’t forget to share it with your loop. Keep reading, keep supporting!

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