Circular flow of income

Representation of Cantillon's primitive circular flow model[6]

One of the earliest ideas on the circular flow was explained in the work of 18th century Irish-French economist Richard Cantillon,[3] who was influenced by prior economists, especially William Petty.[7] Cantillon described the concept in his 1730 Essay on the Nature of Trade in General, in chapter 11, entitled "The Par or Relation between the Value of Land and Labor" to chapter 13, entitled "The Circulation and Exchange of Goods and Merchandise, as well as their Production, are Carried On in Europe by Entrepreneurs, and at a Risk." Thornton eds. (2010) further explained:

Cantillon develops a circular-flow model of the economy that shows the distribution of farm production between property owners, farmers, and workers. Farm production is exchanged for the goods and services produced in the cities by entrepreneurs and artisans. While the property owners are “independent,” the model demonstrates the mutual interdependence between all the classes of people that Adam Smith dubbed the “invisible hand” in The Theory of Moral Sentiments (1759).[8] Cantillon distinguished at least five types of economic agents: property owners, farmers, entrepreneurs, labors and artisans, as expressed in the contemporary diagram of the Cantillon's Circular Flow Economy.[6]

Tableau économique

François Quesnay further developed these concepts, and was the first to visualize these interactions over time in the so-called Tableau économique.[4] Quesnay believed that trade and industry were not sources of wealth, and instead in his 1758 book Tableau économique (Economic Table) argued that agricultural surpluses, by flowing through the economy in the form of rent, wages, and purchases were the real economic movers, for two reasons.

• First, regulation impedes the flow of income throughout all social classes and therefore economic development.
• Second, taxes on the productive classes such as farmers should be reduced in favor of higher taxes for unproductive classes such as landowners, since their luxurious way of life distorts the income flow.

The model Quesnay created consisted of three economic agents: The "Proprietary" class consisted of only landowners. The "Productive" class consisted of all agricultural laborers. The "Sterile" class is made up of artisans and merchants. The flow of production and/or cash between the three classes started with the Proprietary class because they own the land and they buy from both of the other classes. Quesnay visualised the steps in the process in the Tableau économique.

In Marxian economics, economic reproduction refers to recurrent (or cyclical) processes[9] by which the initial conditions necessary for economic activity to occur are constantly re-created.[10]

Economic reproduction involves the physical production and distribution of goods and services, the trade (the circulation via exchanges and transactions) of goods and services, and the consumption of goods and services (both productive or intermediate consumption and final consumption).

Karl Marx developed the original insights of Quesnay to model the circulation of capital, money, and commodities in the second volume of Das Kapital to show how the reproduction process that must occur in any type of society can take place in capitalist society by means of the circulation of capital.[11]

Marx distinguishes between "simple reproduction" and "expanded (or enlarged) reproduction".[12] In the former case, no economic growth occurs, while in the latter case, more is produced than is needed to maintain the economy at the given level, making economic growth possible. In the capitalist mode of production, the difference is that in the former case, the new surplus value created by wage-labour is spent by the employer on consumption (or hoarded), whereas in the latter case, part of it is reinvested in production.

The competitive price system adapted from Samuelson, 1961

An important development was John Maynard Keynes's 1933 publication of the General Theory of Employment, Interest and Money. Keynes' assistant Richard Stone further developed the concept for the United Nations (UN) and the Organisation for Economic Co-operation and Development to the systems, which is now used internationally.

The first to visualize the modern circular flow of income model was Frank Knight in 1933 publication of The Economic Organization.[13] Knight (1933) explained:

[we may view the] economic organization as a system of prize relations. Seen in the large, free enterprise is an organization of production and distribution in which individuals or family units get their real income, their "living," by selling productive power for money to "business units" or "enterprises", and buying with the money income thus obtained the direct goods and services which they consume. This view, it will be remembered, ignores for the sake of simplicity the fact that an appreciable fraction of the productive power in use at any time is not really employed in satisfying current wants but to make provision for increased want-satisfaction in the future; it treats society as it would be, or would tend to become, with progress absent, or in a "static" state.[14]

Knight pictured a circulation of money and circulation of economic value between people (individuals, families) and business enterprises as a group,[15] explaining: "The general character of an enterprise system, reduced to its very simplest terms, can be illustrated by a diagram showing the exchange of productive power for consumption goods between individuals and business units, mediated by the circulation of money, and suggesting the familiar figure of the wheel of wealth."[16]

Two-sector circular flow diagram

In the basic two-sector circular flow of income model, the economy consists of two sectors: (1) households and (2) firms.[17][18] (Some sources refer to households as "individuals"[19] or the "public"[20] and to firms as "businesses"[1][2] or the "productive sector."[21]) The model assumes that there is no financial sector, no government sector, and no foreign sector. In addition, the model assumes that (a) through their expenditures, households spend all of their income on goods and services or consumption and (b) through their expenditures, households purchase all output produced by firms.[18] This means that all household expenditures become income for firms. The firms then spend all of this income on factors of production such as labor, capital and raw materials, "transferring" all of their income to the factor owners (which are households). The factor owners (households), in turn, spend all of their income on goods, which leads to a circular flow of income.[20][18][22]

Three-sector circular flow diagram

The three-sector model adds the government sector to the two-sector model.[17][18] Thus, the three-sector model includes (1) households, (2) firms, and (3) government. It excludes the financial sector and the foreign sector. The government sector consists of the economic activities of local, state and federal governments. Flows from households and firms to government are in the form of taxes. The income the government receives flows to firms and households in the form of subsidies, transfers, and purchases of goods and services.[17][18] Every payment has a corresponding receipt; that is, every flow of money has a corresponding flow of goods in the opposite direction.[17][18] As a result, the aggregate expenditure of the economy is identical to its aggregate income, making a circular flow.

The four-sector model adds the foreign sector to the three-sector model.[17][18][23] (The foreign sector is also known as the "external sector," the "overseas sector,"[19] or the "rest of the world.") Thus, the four-sector model includes (1) households, (2) firms, (3) government, and (4) the rest of the world. It excludes the financial sector. The foreign sector comprises (a) foreign trade (imports and exports of goods and services) and (b) inflow and outflow of capital (foreign exchange).[18] Again, each flow of money has a corresponding flow of goods (or services) in the opposite direction.[18] Each of the four sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. The addition of the foreign sector

The five-sector model adds the financial sector to the four-sector model.[19] Thus, the five-sector model includes (1) households, (2) firms, (3) government, (4) the rest of the world, and (5) the financial sector. The financial sector includes banks and non-bank intermediaries that engage in borrowing (savings from households) and lending (investments in firms).[19] Money facilitates such an exchange smoothly. Residuals from each market enter the capital market as savings, which in turn are invested in firms and the government sector. Technically speaking, so long as lending is equal to borrowing (i.e., leakages are equal to injections), the circular flow will continue indefinitely. However, this job is done by financial institutions in the economy.

• 
  Five-sector circular flow of income model
• 
  Circular flow diagram, five-sectors model

The progression from the two-sector model to the five sector model as documented above (that is, by starting with households and firms, then successively adding the government sector, the foreign sector, and the financial sector) is common. However, some authors group (1) households, (2) firms, and (3) the financial sector together as the "private sector" and subsequently add (4) the government sector, making the "domestic sector," and (5) the foreign sector.[19] Others use the "capital market" rather than the "financial sector" to account for the flows of savings and investments; in these sources, the fully specified model has four sectors (households, firms, government, and foreign) plus the capital market, which is regarded as a market rather than a sector.[18]

The five-sector model considers leakages and injections.

• 'Leakage' means withdrawal from the flow. When households and firms save part of their incomes it constitutes leakage. They may be in form of savings, tax payments, and imports. Leakages reduce the flow of income.
• 'Injection' means the introduction of income into the flow. When households and firms borrow savings, they constitute injections. Injections increase the flow of income. Injections can take the forms of investment, government spending and exports. As long as leakages are equal to injections, the circular flow of income continues indefinitely. Financial institutions or capital market play the role of intermediaries. This means that income individuals receive from businesses and the goods and services that are sold to them do not count as injections or leakages, as no new money is being introduced to the flow and no money is being taken out of the flow.

Leakages and injections can occur in the financial sector, government sector and overseas sector:

In terms of the circular flow of income model, the leakage that financial institutions provide in the economy is the option for households to save their money. This is a leakage because the saved money cannot be spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector. An example of a group in the finance sector includes banks such as Westpac or financial institutions such as Suncorp.

The leakage that the government sector provides is through the collection of revenue through taxes (T) that is provided by households and firms to the government. This is a leakage because it is a leakage out of the current income, thus reducing the expenditure on current goods and services. The injection provided by the government sector is government spending (G) that provides collective services and welfare payments to the community. An example of a tax collected by the government as a leakage is income tax, and an injection into the economy can be when the government redistributes this income in the form of welfare payments, that is a form of government spending back into the economy.

The main leakage from this sector are imports (M), which represent spending by residents into the rest of the world. The main injection provided by this sector is the exports of goods and services which generate income for the exporters from overseas residents. An example of the use of the overseas sector is Australia exporting wool to China: China pays the exporter of the wool (the farmer), therefore, more money enters the economy, thus making it an injection. Another example is China processing the wool into items such as coats and Australia importing the product by paying the Chinese exporter; since the money paying for the coat leaves the economy, it is a leakage.

In terms of the five sector circular flow of income model the state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy. This can be shown as:

This can be further illustrated through a fictitious economy where:

Therefore, since the leakages are equal to the injections the economy is in a stable state of equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of equilibrium the sum of total leakages does not equal the sum of total injections. By giving values to the leakages and injections the circular flow of income can be used to show the state of disequilibrium. Disequilibrium can be shown as:

Therefore, it can be shown as one of the below equations where:

The effects of disequilibrium vary according to which of the above equations they belong to.

If S + T + M > I + G + X the levels of income, output, expenditure and employment will fall causing a recession or contraction in the overall economic activity. But if S + T + M < I + G + X the levels of income, output, expenditure and employment will rise causing a boom or expansion in economic activity.

Circular flow of income effects of saving

To manage this problem, if disequilibrium were to occur in the five sector circular flow of income model, changes in expenditure and output will lead to equilibrium being regained. An example of this is if:

S + T + M > I + G + X the levels of income, expenditure and output will fall causing a contraction or recession in the overall economic activity. As the income falls households will cut down on all leakages such as saving, they will also pay less in taxation and with a lower income they will spend less on imports. This will lead to a fall in the leakages until they equal the injections and a lower level of equilibrium will be the result.

The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the levels of income, expenditure and output will greatly rise causing a boom in economic activity. As the households income increases there will be a higher opportunity to save therefore saving in the financial sector will increase, taxation for the higher threshold will increase and they will be able to spend more on imports. In this case when the leakages increase the situation will be a higher level of equilibrium.