Introduction

In this article, we discuss the circular flow of income within an economy, and aggregate demand (“AD”) – the total demand for goods and services within an economy at given price levels.

Circular flow of income

The circular flow of income describes the flow of money and resources within an economy, and the injections and leakages from that flow. In this diagram, transfers of factors of production (such as labour and land) are known as the real flow, and transfers of money are known as the money flow.

It’s difficult to illustrate all flows which occur in the real world in one diagram, and there are a number of circular flow of income models incorporating various sectors. The diagram below represents the five-sector model, but you may see others in different sources which provide more or less detail.

It is helpful to think of the economy as a bubble:

In the diagram, we have five distinct groups:

1. Firms - producers / suppliers of goods and services, employers of labour and other factors of production, payers of tax, providers of financial capital to financial institutions. Firms may also consume goods and services from other firms;
2. Households - consumers of goods and services, providers of labour and other factors of production to firms (including financial capital and land in some cases), payers of tax, and providers of financial capital to financial institutions;
3. Financial institutions - aggregators of financial capital (savings) from firms and households, providers of loans to households and investment (including loans) to producers. Also employers of labour, payers of tax, and consumers of goods and services. Domestic financial institutions may also make investments (debt or equity) in overseas firms;
4. Government - collectors of tax, providers of welfare and public services, consumers of goods and services, investors in firms, and employers of labour;
5. ‍Overseas - overseas producers / suppliers of goods and services, employers of labour, payers of tax, providers of financial capital to financial institutions (if using institutions outside of their own economy), consumers of goods and services.

Inner flow

Within the economy, we have an inner flow. This includes:

1. The provision of labour and other factors of production (such as land or direct investment) from households to firms;
2. The wages that domestic firms pay to their domestic labour force, and any dividends from direct investments;
3. Goods and services bought by households from domestic firms; and
4. Goods and services that domestic firms might buy from other domestic firms – however, where domestic firms acquire capital goods (human made assets that are used in production e.g. machinery) these are deemed to be an injection into the inner flow – see below.

From this circular flow of income, there are also:

1. Injections - which increase the value of the flow within the domestic economy; and
2. Leakages - which reduce the value of the flow within the domestic economy.

In the above diagram, we have assumed money goes directly between firms and households. However, money is increasingly held in electronic form with a financial institution. Accordingly, payments between households and firms may be a transfer of funds between payment accounts held by firms and households with financial institutions. For our purposes, it suffices to treat such payments as part of the inner flow, because they are being used and are distinct from savings (which we discuss below).

Injections

Investment (I) - Investment is money that firms spend on capital goods, which are human made assets used in production e.g. machinery and equipment. This is to be distinguished from the concept of obtaining monies from investors, which is also commonly known as investment.

Even where firms spend money on investment that they have obtained from households, this counts as an injection because (theoretically) this spending increases overall productive capacity.

However, firms can also obtain money from investors outside the inner flow to spend on such capital goods, which acts as an entirely new injection into the economy.

These investors may comprise of:

1. Domestic financial institutions using money (financial capital) that is stored with them;
2. Foreign financial institutions and foreign private investors using money from abroad as a totally new injection into the economy.

Firms can receive money from investors in various ways, such as through loans or bond issuances (debt) or an issuance of shares (equity) – these are discussed in more detail in other sections of this website.

Note: We have counted money that domestic investors provide to firms as part of the inner flow, even if money is coming from savings stored with a financial institution. This is because money may be notionally (not physically) withdrawn from savings before being invested.

Non-investment payments from financial institutions - Financial institutions may make loans to households, pay interest on savings, dividends on investments held with them, and allow firms or households to withdraw money. If these funds are spent within the inner flow (i.e. aren’t just kept as additional savings), they will in effect be injections into the economy. However, in the circular flow of income model, they are not deemed to be injections in themselves.

Instead, they are grouped with savings, which are withdrawals from an economy. Savings with a financial institution, minus personal loans and other such withdrawals, are known as net savings (see below).

Financial institutions will also employ labour, and pay wages to households.

Government spending (G) - Governments receive money from taxes, borrowing, and returns on investments (if any). They can spend this money on a variety of goods and services, including infrastructure projects such as building roads, hospitals, schools etc.

This expenditure is an injection into the economy.

However, not all money governments receive will be spent on goods and services for the economy; some may be used to pay off interest and principal on money borrowed in the past - these payments are not counted towards government spending.

Further, governments may make welfare payments (also known as transfer payments). Transfer payments are grouped with taxes, which are withdrawals, and are not counted as government spending. Taxes minus welfare payments are known as net taxes.

Governments will also pay wages to households for labour employed.

Exports (X) - Injections into the economy may also come from foreign firms and households buying goods and services.

Withdrawals / leakages

Net savings - The inner flow deals with domestic income (firms and households) that is used to acquire goods and services (including factors of production, such as labour).

In some cases, households or firms may not wish to use the income that they have generated in this way. Instead, they may want to save or invest it with a financial institution, which could lock up that money from being used in the economy.

However, financial institutions may make loans to households and firms, and may provide other investment to firms. Savings with a financial institution, minus such loans and investment, are known as net savings.

Net taxes - When firms and households pay taxes to the government, this proportion of their income is removed from the circular flow of income. Some taxes will be paid back to households in the form of welfare payments (also known as transfer payments). The difference between the taxes collected and welfare / transfer payments are known as net taxes, which constitute withdrawals from the economy.

These taxes may be re-injected into the economy by government spending on goods and services. However, as discussed above, not all taxes will be spent on goods and services and maybe used to repay interest or principal on borrowing; in these cases, the taxes remain withdrawals from the economy.

As will be shown later in our discussions about gross domestic product (GDP), governments generally want to ensure their spending maximises GDP overall through either maximising AD and aggregate supply (“AS”), or both (depending on the state of an economy - we will discuss this later).

Import expenditure (M) - A portion of firms’ and households’ income is spent on goods and services from outside the economy: imports. This proportion of income is removed from the circular flow of income within an economy.

A quick point to note on the interconnectedness of the global economy – as above, investment and government spending are considered to be injections into the economy. However, where firms or governments purchase goods or services to be used within the economy from abroad, those purchases will also count towards import expenditure (which is a withdrawal from the economy).

Aggregate demand

The circular flow of income is a useful tool to illustrate the concept of AD. AD is the total demand for goods and services within an economy at given prices.

AD within an economy can be calculated as follows: Consumer spending (spending by households) (C), plus investment (I), plus government spending (G), plus exports (X), minus imports (M).

This can be represented more simply as AD = C+I+G+(X-M).

The circular flow of income demonstrates how these components form part of the economy.

AD can be represented as a curve, just like the demand curve in microeconomics – as prices go up, demand goes down.

In macroeconomics we can identify three reasons for the downward slope of the AD curve:

1. Real balance effect - as prices rise, the value of people’s savings will be eroded, and they will therefore save more to compensate;
2. International substitution effect - as prices rise, consumers will be encouraged to buy cheaper substitutes from abroad;
3. Inter-temporal substitution effect - as prices rise, the government / monetary authority may put interest rates up to offset inflation because, with higher interest rates, people will be encouraged to save more and therefore spend less (discussed later in our article on Monetary Policy).

When constructing a single AD curve, we assume that its determinants (C+I+G+(X-M)) are constant at a given price i.e. they don’t change. This is the ceteris paribus (all things being equal) assumption. However, if one of the determinants were to change, this would result in a shift in the AD curve.

For example, if either of C, I, G or X were to increase, and M were to decrease, this would result in an increase in AD, which can be shown by an outward shift in the AD curve.

If either C, I, G or X were to decrease, and M were to increase, this would result in a decrease in aggregate demand, which can be shown by an inward shift in the aggregate demand curve.

There are many reasons the components of AD might change, including (amongst others):

1. Consumer spending - changes in household disposable income, which could be caused by changes in taxes, welfare, interest rates and the availability of credit, and general consumer confidence;
2. Investment - availability of money (which is impacted by interest rates and availability of credit / investment), confidence within an economy, government policy on capital investment, changes in technology which require firms to invest if they are to remain competitive, amount of capital which needs to be replaced over time etc;
3. Government spending - amount of taxes, government borrowing, and interest rates (which impacts the level of repayments on borrowing, how much a government has to spend on the economy, and the affordability of additional borrowing);
4. Imports and exports - relative prices of goods and services around the world, exchange rates, government policy around the world (e.g. taxes on imports and exports, trade deals etc), and non-price factors (e.g. specialist goods and services produced by certain economies, the quality, design, branding and necessity of those goods and services etc).

Have a think about the above factors and consider what might cause the AD curve to shift.

Following our discussions on AS (aggregate supply), it will become clear that the interaction between AD and AS, and the shape and position of the AD and AS curves, affect the overall GDP of an economy, the levels of unemployment, the rate of inflation, and the number of imports and exports.

Conclusion

You should now have a good understanding of the circular flow of income, an AD. In summary:

• Macroeconomics concerns the whole of an economy;
• The circular flow of income illustrates the flow of money and resources within an economy, and injections and leakages from it;
• The circular flow of income is a useful tool to illustrate the concept of AD;
• AD is the total demand for goods and services within an economy at given price levels;
• AD can be calculated as C+I+G+(X-M) and is downward sloping;
• Changes in the determinants of AD will result in shifts in the AD curve;
• The shape and positioning of the AD and AS curves and shifts in them will affect the overall GDP of an economy, the levels of unemployment, the rate of inflation and the number of imports and exports.