Learning Objectives

After you have read this section, friend should have the ability to answer the following questions:

What is the circular flow of income? What is the national income identity?

Looking at some an easy measurements that the economic situation has permitted you to be an ext concrete around the troubles in Argentina. Friend report earlier to the worldwide Monetary fund (IMF) team the production has actually been decreasing in current years. You likewise report the there to be a recent rise in the price level. Together yet, though, you perform not know anything about either the causes or the results of these events. Measure of the economic situation tells girlfriend what has actually happened, but it speak you no why it occurred nor what that means. Measure is not enough. We need frameworks to aid us make feeling of the data that us gather.

You are watching: In the circular flow model, households earn their incomes in the:

Economists use numerous different type of frameworks come make sense of an economy. One of the most essential is dubbed the circular flow of incomeThe money flows among the various sectors of an economy as individuals and firms buy and also sell goods and services.. To know the circular flow, recall our working definition of financial activity: “goods and services developed for sale.” so far, we have concentrated on production. Currently we think about the “for sale” part.

Toolkit: ar 16.16 "The Circular circulation of Income"

As individuals and firms buy and sell goods and also services, money flows among the various sectors the the economy. The circular circulation of income defines these flows of dollars. From a basic version that the one flow, we learn that, together a matter of accounting,

gross residential product (GDP) = income = production = spending.

This connection lies in ~ the love of macroeconomic analysis.

There are two political parties to every transaction. Once you purchase a item of computer system software, you provide money to the seller, and the seller offers the software program to you. (You could literally hand over dollar bills and also receive a CD, or you might enter a credit card number right into a website entitling you come a download. The idea is the very same either way.) there is a flow of money from you come the seller and also a circulation of items or services from the seller to you. This is true for every transactions: as individuals and firms buy and also sell goods and services, money flows among the various sectors that the economy. Macroeconomists follow the money. By tracking this flows, we can understand the links in between different markets; by expertise these links, we acquire insight right into the work of an economy.

One affiliation is in between income and spending. The spending by family members on goods and also services is sponsor by the income that households earn. Yet this income comes from firms, and also they acquire their income from the security of households. Hence there is a circular flow of revenue in an economic climate as a whole.

Household income comes from two key sources: (1) family members contain workers who offer their time come firms and receive earnings in return. (2) family members are the ultimate owner of the firms—shareholders live in homes too—and thus any profits that firms make are returned to households. Every firms in an economy are owned by someone, and also any earnings they make perform not vanish right into thin air however must eventually present up together someone’s income.

Households take this income and also do among two things: castle either spend it or conserve it. Come start, let us figure out what would take place if no household income is saved. Households spend all your income, and this money becomes the revenue of firms. This firm send these revenues back to households, either together labor income or profits, and also so the circular circulation continues.

The most basic Version that the one Flow

We deserve to make this idea much more precise, making use of the pizza economic climate to illustrate. Imagine the our economic climate is composed of two sectors, which we speak to households and firms. Family members supply job to firms and also are paid incomes in return. Firms usage that job to create pizzas and sell those pizzas to households. Over there is a circulation of goods (pizzas) native firms come households and a flow of labor solutions (worker hours) from family members to firms. Due to the fact that there are two sides to every transaction, there is likewise a flow of dollars from families to firms, as family members purchase pizza, and also a circulation of dollars native firms to households, as firms salary workers.

For now, think of firms together very an easy entities that pay the end all the revenue they receive in the kind of wages to workers. Together a result, 300 exchange rate pesos flow from the household sector come the firm sector (the purchase of pizzas) each year, while 300 exchange rate pesos flow from the firm ar to the household sector (the payment that wages). This flows that pesos are illustrated in figure 3.11 "The simplest Version that the circular Flow". Think that this diagram together representing the interaction of numerous households with many firms. A certain household works for one (or maybe a few firms) but purchases goods and also services from countless firms. (If you like, imagine that various firms specialize in various kinds that pizza.) A feature of modern-day economies is that individuals specialize in production of goods and services however generalize in consumption by consuming many varieties the goods and services.

Figure 3.11 The easiest Version of the one Flow

The circular flow of income adheres to the money in one economy. In the pizza economy, firms develop pizzas and also sell them to households, while families sell job to firms and purchase pizzas indigenous them.

The circular circulation reveals the there room several various ways to measure up the level of economic activity. From the family members perspective, we deserve to look at either the lot of revenue earned by families or your level that spending. Native the firm perspective, we deserve to look at either the level of profits earned indigenous sales or the amount of their payments come workers and shareholders. In all cases, the level of in the name of economic task would be measured at 300 billion pesos.

Corresponding come the flows of pesos presented in number 3.11 "The most basic Version of the one Flow", there are flows the goods and services between these sectors, as shown in figure 3.12 "The flows of Goods and Labor within the one Flow". The wage revenue received by consumer is payment for labor solutions that circulation from households to firms. The usage spending of family members is payment because that the items that flow from firms come households.

Figure 3.12 The operation of Goods and Labor within the one Flow


There room flows the goods and also labor services that correspond to the flows of pesos displayed in number 3.11 "The easiest Version the the one Flow". 3 hundred exchange rate pesos worth of pizza flows from firms come households, and also 300 billion pesos worth of job services circulation from family members to firms.

Of course, over there are additionally flows the dollars within the household and also firm sectors and also between them. Importantly, this firm purchase lots of goods and services from various other firms. One of the beauties the the circular circulation construct is that it permits us come describe all at once economic task without having to get in the information of all the flows among firms.

Figure 3.13 "Income, Spending, payment to Inputs, and Revenues in the an easy Circular Flow" mirrors us that the operation in and also out of every sector need to balance. In the family sector, complete spending by the family equals total income because that the household. If spending amounts to income for each separation, personal, instance household, then spending also equals earnings for the household sector together a whole. Similarly, each firm has a balance sheet. Accounting rules certain that every one of a this firm revenues should ultimately present up on the various other side the the balance sheet as payments for the inputs that the firm offers (in our an easy example, the firm’s only input is labor). Together this is true for each separation, personal, instance firm, it is additionally true because that the sector as a whole.

Figure 3.13 Income, Spending, payment to Inputs, and Revenues in the simple Circular Flow


In every household, and thus in the household sector together a whole, income must same spending. In every firm, and thus in the firm sector as a whole, revenues must equal payment to inputs. GDP actions the production of the economic situation and full income in the economy. We have the right to use the terms production, income, spending, and GDP interchangeably.

Although this variation of the circular circulation is simple, it teaches united state four crucial insights that stay true (albeit in slightly sleek forms) in an ext sophisticated versions as well.

Spending = production. The total value of every spending by family members becomes an inflow into the firm sector and thus ends up on the revenue next of a this firm balance sheet. The earnings received through firms provide us v a measure of the total value of production in one economy. Production = payment to inputs. operation in and out of the for sure sector have to balance. The profits received by this firm are ultimately paid out to households. Payments come inputs = income. Firms room legal entities, not people. We may talk in usual speech of a firm “making money,” but any type of income created by a firm must ultimately end up in the hands of actual people—that is, in the family members sector of an economy. The complete value the the goods created by firms becomes an outflow the dollars native the certain sector. These dollars finish up in the hands of family members in the kind of income. (This ownership is completed through countless forms, ranging from this firm that room owned and also operated by individuals to gigantic corporations whose ownership is identified by share holdings. Not all households own this firm in this way, however in macroeconomics the is sufficient to think about the average family members that does very own stock in firms.) Income = spending. We complete the circle by looking in ~ the household sector. The dollars that circulation into the household sector room the income of that sector. They have to equal the dollars that flow out of the household sector—its spending.

The circular circulation of earnings highlights a vital fact of national income accounting:

GDP = revenue = safety = production.

Earlier, we emphasized that GDP steps the manufacturing of an economy. Now we view that GDP is equally a measure up of the revenue of one economy. Again, this reflects the fact that there are two sides to every transaction. We deserve to use the state income, spending, production, and also GDP fully interchangeably.

What walk this average for your assessment the Argentina? because that one thing, it speak you that the decrease in genuine GDP indicates a corresponding decline in income. Economists pay a good deal of attention to genuine GDP statistics for precisely this reason: such statistics administer information on the total amount of earnings earned in an economy.

The complete Circular Flow

Figure 3.14 "The finish Circular Flow" shows a much more complete variation of the circular flow. It includes five sectors: the household and firm sectors the we have actually seen already, a government sector, a jae won sector, and also a foreign sector. In every sector of the one flow, audit rules tell united state that the circulation of money in must equal the flow of money out. As soon as we look in ~ this ar by sector, we find five accounting relationships, every playing an important role in macroeconomics. Because that now, us take a an extremely quick look at every one in turn.When we revisit each sector in various chapters the this book, us include much more precise interpretations and much more detailed discussion of the individual flows (such as intake or federal government purchases).

Figure 3.14 The complete Circular Flow


The circular flow of income defines the operation of money amongst the various sectors of one economy. This representation contains the five main sectors: households, firms, government, the gaue won sector, and also the rest of the world.

The certain Sector

The flows in and also out the the firm sector of an economic climate must balance. The total flow of dollars native the certain sector actions the full value of production in the economy. The full flow the dollars into the firm sector equals total expenditures ~ above GDP, i beg your pardon we division up into four categories.

Toolkit: section 16.16 "The Circular circulation of Income"

The national earnings identityThe problem that manufacturing is the amount of consumption, investment, government purchases, and net exports. Is the problem that

production = usage + invest + federal government purchases + net exports.

It is the most an essential relationship in the national accounts.

Consumption advert to complete expenditures by family members on final goods and also services. Investment refers to the purchase of goods and also services that, in one method or another, aid to produce more output in the future. Government purchases are all the to buy of goods and also services by the government. Net exports are the difference between exports and also imports: they steps the total expenditure flows linked with the rest of the world.These state are described in information in chapter 7 "The an excellent Depression".

The family Sector

Households receive revenue from firms. They additionally receive money indigenous the government (transfers) and also must salary money to the federal government (taxes). Families spend few of their disposable income and also save the rest. In various other words,

income + transfers − taxes = usage + exclusive savings.

There are countless different methods of saving, however we carry out not focus on these differences. We just imagine that family members take their savings to financial industries to purchase interest-bearing assets. Part individual families are net borrowers, but, overall, the family sector saves. Over there is, ~ above net, a circulation of dollars indigenous the family members sector come the financial sector of an economy. These dollars are then accessible for firms to borrow to build new factories, download up-to-date equipment, and so on. The is, lock are easily accessible for investment.The operation in and also out of the family sector are questioned in thing 12 "Income Taxes".

The federal government Sector

From a macroeconomic perspective, the crucial functions of government are as follows:

the purchases goods and also services. It collects revenues through an individual and corporate taxes and also other fees. It gives transfers come households.

The amount the the federal government collects in taxes does not must equal the amount that it pays the end for government purchases and transfers. If the government spends an ext than that gathers in taxes, climate it must borrow indigenous the financial industries to comprise the shortfall.

Figure 3.14 "The finish Circular Flow" mirrors two flows right into the federal government sector and one flow out. Since the operation in and out the the government sector should balance, we know that

federal government purchases = tax profits − transfers + federal government borrowing.

Government borrowing is frequently referred to together the budget plan deficit. It is also possible that the government takes in more than that spends, in which situation the federal government is saving quite than borrowing, so there is a spending plan surplus quite than a deficit.Government finances are discussed in thing 14 "Balancing the Budget".

The financial Sector

The financial sector of an economic situation is in ~ the heart of the circular flow. That summarizes the habits of banks and also other gaue won institutions. Many importantly, this ar of the circular circulation shows united state that the save of households carry out the resource of invest funds because that firms. ~ above the left-hand side, the figure shows a circulation of dollars indigenous the family members sector into financial markets, representing the conserving of households. (Though we have not included it in figure 3.14 "The finish Circular Flow", firms also save, by method of profits that they retain to finance new investment quite than distribute to their shareholders. As far as the national accounts space concerned, it is together if firms sent out these funds to the financial market and then obtained them earlier again.) when we loaned from other countries, there is a 2nd flow of dollars right into the financial markets. On the right-hand side, there is a flow of money native the financial sector right into the firm sector, representing the funds the are available to firms for invest purposes. The linkage in between the conserving of households and also the investment of firms is just one of the many important ideas in macroeconomics.

The financial sector is also linked come the federal government sector and the international sector. This flows can go in one of two people direction. Together we have currently seen, if the government runs a deficit, it does for this reason by borrowing from the jae won markets. Over there is a circulation from the financial ar to the federal government sector. This is the situation we have attracted in figure 3.14 "The finish Circular Flow". If the federal government were to operation a surplus, the flow would go in the other direction: government would provide secondary source of saving. The foreign sector deserve to provide secondary source the funds for investment, if those in other countries decide they desire to use several of their to save to purchase assets in our economy. In this case, there is a circulation from the international sector right into the jae won sector. Again, this is the situation we have actually drawn. If us lend to various other countries, climate the circulation goes in the various other direction.

The operation in and also out the the gaue won sector need to balance, so

invest + government borrowing = private savings + borrowing from other countries.

The foreign Sector

The foreign sector is perhaps the hardest part of the circular circulation to understand since we have to know exactly how international transactions are brought out.

Some that the goods created in an economic situation are not consumed by domestic households or firms in an economy however are instead exported to other countries. At any time one country sells something to another country, it acquires an asset native that nation in exchange. Because that example, expect a us movie agency sells DVDs to an Australian distributor. The simplest method to imagine this is to suppose that the distributor hands end Australian dollar receipt to the movie company. The movie company—and, much more generally, the united state economy—has now acquired a foreign asset—Australian dollars.

Because this Australian dollars have the right to be used to purchase Australian goods and services at some time in the future, the US economic climate has gained a insurance claim on Australia. In effect, the united States has actually made a loan to Australia. It has sent items to Australia in exchange for the promise that it can claim Australian commodities at part future date.

Similarly, few of the items consumed in our economy are not created locally. Because that example, mean that a united state restaurant chain purchases Argentine beef. These space imports. We might imagine the the restaurant chain hand over us dollars come the Argentine farmers. In this case, the United says has borrowed from Argentina. It has actually received items from Argentina however has promised that it will give some products or services to Argentina in the future.

Of course, worldwide transactions in practice are more facility than these straightforward examples. However the understanding we have just uncovered remains true no matter just how intricate the basic financial transactions are. Exports are identical to a loan to the rest of the world. Imports are equivalent to borrowing indigenous the remainder of the world.

If we import much more than us export, climate we are borrowing from the remainder of the world. We can see this by looking at the operation in and also out that the international sector:

get loan from overseas = imports − exports.

If we export an ext than us import, then—on net—we room lending come the remainder of the world, and also there is a flow of dollars indigenous the financial sectors to the remainder of the world.

See more: Why Did The Mariner Kill The Albatross, Why The Mariner Killed The Albatross

The reasons of a diminish in genuine GDP

We witnessed that, in Argentina, actual GDP decreased between 1998 and 2002. The circular flow of revenue tells united state that as soon as real GDP decreases, the must likewise be the case that real manufacturing decreases and real safety decreases. The IMF team in 2002 want to know why real GDP decreased. We room not going to answer that inquiry in this chapter—after all, we space still in ~ the really beginning the your examine of macroeconomics. Still, the circular flow still teaches united state something an extremely important. If genuine GDP decreased, then there space really just two possibilities:

For some reason, firms determined to develop less output. Together a consequence, households decreased their spending. For some reason, households decided to spend much less money. Together a consequence, firms lessened their production.

Of course, it can be the situation that both of these room true. This insight from the circular circulation is a starting point for explaining what taken place in Argentina and what wake up in other countries when calculation decreases.

Key Takeaways

The circular flow of income illustrates the links in between income and spending in one economy. In its easiest form, revenue earned by that company by offering their output eventually flows to households, which invest this revenue on the output created by firms. The national income identification says that total spending must equal complete output and also must equal total income.

Checking her Understanding

We claimed that borrowing indigenous abroad amounts to imports minus exports. Is there an analogous connection that holds for an individual?