Notes

The circular flow of income shows how money is circulated in the economy as income and expenditure and it involves all four sectors of the economy; households, firms, government and foreign sector.

It illustrates how all expenditure on the final output of a nation is equal to the money value of that output, ends up as someone's income. ie every dollar of spending by a buyer ends up as a dollar of income for a seller.

In a 4 sector economy, households supply land, capital, labour and entrepreneurial ability to firms and are paid factor incomes; wages, rent, interest and profit in return.

Out of this income received, households spend a portion of it on goods and services produced by firms. This constitutes consumption expenditure and is paid to firms who will use this money to hire factors of production to produce, consequently paying out income to factor owners.

Hence, the expenditure of households ends up as income for firms that end up as income for households again. The remaining income not spend by households leaks out of the circular flow as savings, taxes and import expenditure to the financial intermediaries, government sector and foreign sector respectively. These leakages are also known as withdrawals.

Besides receiving payments from households for the goods and services they produce, firms also receive payments from the government sector, foreign sector and other firms in the form of government expenditure, export revenue and investments. These payments I, G and X, excluding C, are known as injections.

When the total withdrawals is equal to the total injection, we can say that the national income is in equilibrium.