Lesson preview · Circular Flow
The Circular Flow of Income
~10 min · Free to read
Every dollar on your last paycheque came from somewhere. Your employer earned it from a customer. That customer earned it from their employer. And so on, all the way around the economy. Every dollar you spend at a coffee shop becomes someone else’s income.
The economy is a giant loop. Money flows around it in one direction; goods and labour flow the other way. The diagram that shows this — the circular flow — is the most useful sketch in macroeconomics.
Start with the simplest version. Two actors: households and firms. Households own the inputs that produce things — their own labour, savings they’ve turned into capital, and land they own. Firms hire those inputs and use them to produce goods and services.
Money flows in a loop. Households sell their labour to firms and receive wages. Then they spend those wages buying goods, which sends the money back to firms. Firms then pay it out again as wages. The same dollar goes around and around.
Key Term
The fundamental macro identity
Total spending = total output = total income. The same number, viewed three ways. Every dollar a firm earns from selling goods (output) it pays out as wages, rent, interest, or profit (income), and every dollar a household earns it eventually spends or saves (spending). This identity is the spine of every macro model in the course.
Two more actors complete the picture. Government taxes households (T) and spends that money (G) — on roads, defence, schools, transfers. The rest of the world sells us imports (M) and buys our exports (X). Add them all up and you get the most famous equation in macroeconomics:
GDP from the spending side: consumption + investment + government + net exports.
Some money leaks out of the spending loop. When you save, that dollar isn’t being spent. When you pay tax, it goes to the government — not directly to firms. When you buy an imported phone, your spending leaves the country. These are leakages.
Other money gets injected back in. Firms borrow savings and invest them in new factories. Governments spend the tax they collected. Foreigners buy our exports. These are injections.
Key Term
Leakages and injections
Leakages — money that exits the active spending stream: saving (S), taxes (T), imports (M).
Injections — money that enters the active spending stream: investment (I), government spending (G), exports (X).
In equilibrium, total leakages equal total injections — the loop balances.
Leakages equal injections in equilibrium — the algebraic flipside of Y = C + I + G + (X − M).
Trap · Common Misconception
Imports don't make the country poorer
Imports show up as a subtraction in Y = C + I + G + (X − M), which makes it look like they shrink the economy. They don’t. They subtract because the goods you bought were produced abroad — they’re already counted in C, I, or G, so we subtract them to avoid double-counting our domestic output. Imports satisfy real demand and free up domestic resources for other uses. They are not a national loss.
Check yourself · no marks
A household earns 4,000 dollars in wages, spends 3,000 on US-made goods, 200 on an Italian sofa, pays 600 in taxes, and saves 200. Which parts are leakages?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Worked Example
An American household saves 1,000 dollars in a bank. The bank lends it to a US firm, which spends it on a new machine. Trace this money through the circular flow.
Practice · 1 / 4
Which of the following is NOT a leakage from the circular flow?
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