Economic Flows (Unit 1 Topic 2)
Circular Flow of Income
The Circular Flow of Income: the Fundamentals
At its simplest, the economy is a loop. Households own the factors of production — land, labour, capital and enterprise — and supply them to firms. Firms pay wages, rent, interest and profit in return, which becomes household income. Households then spend that income on the goods and services firms produce. Money flows one way around the circuit; goods, services and resources flow the other.
That two-sector loop is only the core. In reality, money leaves the circuit and enters it from elsewhere.
Leakages and injections
Three flows drain income out of the loop. Savings (S) is income households set aside rather than spend. Taxation (T) is income claimed by government. Imports (M) is spending that goes to overseas producers instead of domestic firms. Together these are leakages — income received but not passed back to local firms.
Three flows put money back in. Investment (I) is firms spending on capital goods, funded through the financial sector. Government expenditure (G) returns tax revenue to the economy. Exports (X) is overseas spending on domestic output. These are injections.
The circular flow is in equilibrium when S + T + M = I + G + X. It's the totals that must match, not each pair. When injections exceed leakages the flow expands, output and employment rise, and inflationary pressure can build. When leakages dominate, the flow contracts and unemployment rises.
Note that aggregate demand, AD = C + I + G + (X − M), excludes savings and taxation. They aren't spending on domestic output — but they still shrink the flow by reducing the income available to spend.
Using the interactive
Each slider changes one flow. Move it and that flow thickens or thins on the diagram, lights up, and the household–firms sector visibly expands or contracts with the change in activity. Hover a slider to isolate its flow.
Watch the outcomes strip for AD, total injections, total leakages, net trade and the net effect on the flow.
Try the scenario buttons — fiscal stimulus, austerity, import surge — predicting the direction before you click.