The circular flow of income model is a model used to show the flow of income through an economy. Through showing the leakages in the economy and the injections, the different factors affecting the economic activities are apparent. Just like a leakage in a fish tank a leakage in the economy leads to a decrease in economic activity.
And just like an injection into a fish tank where the water level rises, an injection in an economy leads to an increase in economic activity. To understand how the circular flow of income can be used to show disequilibrium in the economy you must first understand what disequilibrium is. Disequilibrium is the state where economic activity is not equal, that is where leakages > injections or when leakages
The basic circular flow of income model consists of six assumptions:
· he economy consists of two sectors: households and firms.
· Households spend all of their income (Y) on goods and services or consumption (C). There is no
saving (S).
· All output (O) produced by firms is purchased by households through their expenditure (E).
· There is no financial sector.
· There is no government sector.
· There is no overseas sector.
In the simple two sector circular flow of income model (Fig 1) the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is: Y = E = O.
This means that all household income (Y) is spent (E) on the output (O) of firms, which is equal in value to the payments for productive resources purchased by firms from households. This can be shown in an example where John earns $100.00, he doesn’t save it and spends it all on the goods and services (O) provided by the firms.
Table all leakages and injections in five sector model:
| LEAKAGES | INJECTION |
| Saving (S) | Investment (I) |
| Taxes (T) | Government Spending (G) |
| Imports (M) | Exports (X) |
The five sector model of the circular flow of income is a more realistic representation of the economy. Unlike the two sector model where there are six assumptions the 5 sector circular flow runs on the basis that all the 6 assumptions are relaxed. Since the first assumption is relaxed there are 3 more sectors introduced. The first is the Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing (savings from households) and lending of money.
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 there money. This is a leakage because the saved money can not 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 next sector introduced into the circular flow of income is the Government Sector that consists of the economic activities of local, state and federal governments in Australia. 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. For this reason they are 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 final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to an open economy. The main leakage from this sector are imports (M),in the context of Australia imports represents spending by Australian residents into the rest of the world. The main injection provided by this sector is the exports of goods and services where again in the context of Australia generates income for the exporters from overseas residents.
An example of the use of the overseas sector is where Australia exports 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 where China processes the wool into items such as coats and Australia imports 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 5 sector circular flow of income model (Fig 2) 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:
>Savings + Taxes + Imports = Investment + Government Spending + Exports,or: S + T + M = I + G + X.
This can be further illustrated through the fictitious economy of Noka where:
· S + T + M =I + G + X
· $100 + $150 + $50 = $50 + $100 + $150
· $300 = $300
Figure 3: Equilibrium
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 use to show the state of disequilibrium. Since disequilibrium can be shown as:
>S + T + M I + G + X,
Therefore it can be shown as one of the below equations where:
· Total leakages > Total injections
· $150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + 150 (X)
Or
· Total Leakages < Total injections
· $50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + 150 (X)
The effects of disequilibrium vary according to which of the above equation 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.
But to manage this problem if disequilibrium was 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 (Figure 4) 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 household’s 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 they will continue to rise until they are equal to the level injections. The end result of this disequilibrium situation will be a higher level of equilibrium.
This is how the circular flow of income model can be used to explain how disequilibrium in the economy occurs.
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