The Circular Flow of Income
Product Market The market for consumer goods and services.
Factor Market The market for the factors of production. (land, labour,
capital, and enterprise)
Household Sector Made up of clusters of individuals.
Business Sector Made up of businesses of various types and sizes, from
small family-run proprietorships to large corporations.
The four factors of production are combined to produce the goods and services
that individuals consume on a daily basis.
In our private enterprise or pure market economy, the factors of production are,
ultimately, owned by individuals.
Individuals control the sale of their own labour;
Individuals own land and mineral rights; and
Individuals own the shares of a corporation’s assets or (for our purposes)
The factors of production therefore, flow from the household sector, through the
factor market, to the business sector.
The business sector must pay for the factors they receive. This payment flows
from the business sector into the household sector, and becomes income.
Incomes take a variety of forms:
Rent (r): the payment made and the income received for the use of land.
(i.e. the payment for the use of a natural resource, and not simply the
payment for the use of an apartment or other building.)
Wages (w): the payment made and the income received for the use of
labour. (includes commissions, tips, and all employee benefits.)
Interest (i): the payment made and the income received for the use of
Profits (): the income received from the activity of enterprise. (The
income which is left over after all the factors of production have been paid.
Profits can be thought of as a reward for enterprise.)
Businesses use the factors of production to produce consumer goods and services.
These goods and services flow from the business sector, through the product market,
to the household sector.
Households use the income received from the sale of factors to pay for these
consumer goods and services. In other words, they engage in consumption.
Consumption: the expenditure by households on goods and services.
Each buy/sell transaction in either market is income to one sector and spending to the
other. Thus, national income is the sum of all incomes from such transactions or the
sum of all spending.
Income: the earnings of factors of production expressed as an amount per period of
Money: any medium of exchange which is widely accepted.
In 1997, Canada’s stock of money was approximately $73 billion while the flow of
income during the same year was approximately $605 billion.
Complications to the Circular Flow of Income
Leakages: income received from the circular flow which does not flow directly back.
The leakages include: savings, imports, and taxes.
Injections: An expenditure received by firms in the business sector that does not
come from the household sector and is not dependent on the current flow
The injections include: exports, investment, and government spending.
Savings and Investment
Households do not necessarily spend all of their income on consumption. Some of it is also
spent on savings.
Savings (S) can be defined as income (Y) received but not spent on consumption (C).
Savings are a leakage from the circular flow of income. The amount of savings is dependent
on the level of income. In other words, savings is a function of income.
S = f(Y)
Savings normally flow to financial intermediaries. (Although some may be tucked away in a
cookie jar or under a mattress.)
Current-period savings is a flow that comes from the current flow of income. Accumulated
savings which is held over from the previous period’s income is a stock. Therefore people’s
stock of savings changes as a result of the current flow.
Wealth is the sum of all valuable assets ( i.e. real estate, fine cars, art work, etc. as well as
bonds, term deposits, and savings accounts) minus liabilities.
Loanable funds are that portion of wealth that is available for loan through financial
intermediaries. (Stock of savings available in financial intermediaries.)
Investment is defined as spending that results in a physical increase in plant, equipment, or
machinery (i.e. spending that increases the economy’s capital stock). It also includes
changes in the value of inventory, and spending on all construction (including residential
Most investment results in an increase in the economy’s capacity to produce goods and
services and is done by business for profit.
Investment is an injection into the circular flow of income.
Savings is a leakage from the circular flow of income. Most, but not all of it flows
into the various financial intermediaries and thus becomes part of the economy’s
loanable funds. These loanable funds provide the means for business to borrow in
order to finance investment which is an injection into the circular flow of income.
Imports and Exports
Some of the goods and services that households buy, as well as some of the investment
goods purchased by businesses, are goods and services imported from outside the domestic
(or Canadian) economy. This type of spending is referred to as import spending or just plain
Import expenditures do not flow back into the domestic economy, but instead leak out. It is
therefore a leakage from the circular flow of income.
Because the decision to buy imported goods is made by individuals or households, imports
are illustrated as a leakage from the household sector.
The business sector receives payment for goods and services exported, and this payment is
in addition to the consumption expenditure from (domestic) households.
Exports are goods and services produced in one country and sold to another country.
Exports are an injection to the circular flow of income. It is illustrated as an injection to the
Government Spending and Taxes
To look at this set of injections and leakages, we need to add another sector to our analysis –
the government sector.
The government sector taxes both the household sector and the business sector. These taxes
(T) are the third leakage.
The government sector also purchases goods and services from the business sector. This
government spending (G) on goods and services is the third injection.
The government also disburses what are called transfer payments (TP). These are defined
as payments made for which there are no goods or services given in exchange (at the time of
the payment). Examples would be welfare, child support payments, and subsidies or
research grants to businesses. Transfer payments are shown as flowing directly into the
Three Leakages: Three Injections:
Savings (S) Investments (I)
Imports (IM) Exports (X)
Taxes (T) Government (G)
Equilibrium is a state of balance or equality between opposing forces. The opposing forces here
are leakages on the one hand, and injections on the other.
If these two opposing forces are in balance, i.e. if:
S + IM + T = I + X + G
then the level of national income will remain unchanged and can be said to be in
If leakages exceed injections, i.e. if:
S + IM + T I + X + G
then the level of income will fall.
If leakages are less than injections, i.e. if:
S + IM + T I + X + G
then the income level will rise.
The next step in analysing the equilibrium of the circular flow is to understand that the value of all
output in an economy is exactly the amount for which that output is sold. This is because output has
no measurable value until it is sold. Therefore:
The value of production = total receipts of producers.
It follows then that:
Total receipts of producers = total expenditures.
Everything that is produced in a given year is not necessarily sold in that year. That portion of
production which is not sold is added to producers’ inventories. As mentioned before, these
inventory changes are included within the definition of investment. Therefore, the statement above
holds true in that any unexpected build-up in inventories caused by a decrease in consumption
spending will be offset by an increase in inventory spending.
Aggregate expenditures: total spending in economy divided into 4 components: C, I, G, & (X-IM).
Total receipts by producers = aggregate expenditures.
Total receipts by producers will become income in the sense that what firms receive, they ultimately
pay out in the form of wages, interest, rents, or profits. This leads us to:
Total income = aggregate expenditures.
National Income Measurement
Gross Domestic Product (GDP): the money value (at market prices) of all final goods and services
produced in Canada within a given time period such as a
month, quarter, or year.
National Income (Y): the total earnings of all factors of production within the economy in a given
GDP = AE = Y
Gross National Product (GNP): measures the value (at market prices) of all final goods and
services produced by the citizens of Canada regardless of the
location of production.
Net National Product (NNP): GNP less capital consumption (or depreciation).
Gross Domestic Income: incomes earned in Canada (equals the sum of wages, profits,
interest, farm, and self-employed income).
Expenditures Approach to Measuring GDP
This approach adds up the four forms of expenditures:
I Investment Spending
G Government spending on Goods and Services
and then subtracts spending on imports (IM).
AE = GDP = C + I + G + (X – IM)
Net exports: total exports minus total imports of goods and services which can be written as
(X – IM) or as Xn.
Consumption Includes spending on consumer durables (cars, household appliances,
etc.); semidurables (clothes); nondurables (food and beverages, etc.);
and consumer services (travel agents, hairdressers, etc.).
Investment Spending on machinery and equipment, on all construction (including
houses) and on changes in inventory. The term Ig is used to represent
gross investment – i.e. before any depreciation is taken into account.
Government The total spending on goods and services at all levels of government.
Spending (It does not include transfer payments or subsidies.)
Net Exports Total value of all exports (whether of consumer goods, capital goods,
or government goods and services) less the total value of all imports.
The actual figures (in billions of $’s) for Canada in 1997 were as follows:
C + Ig + G + Xn = GDP
505 149 187 +15 856
GDP at market prices 856
+ / - net foreign investment income -28
= GNP at market prices 828
Income Approach to Measuring GDP
This approach adds up the five forms of incomes:
Wages & Salaries
Wages & Salaries Includes all benefits received and is expressed as gross earnings
before taxes or deductions.
Gross Profits Earnings of corporations before any distribution of dividends or
payment of taxes.
Interest & Investment Includes business interest only, and not interest on consumer
Incomes loans or on loans to government.
Farmers’ Incomes Self – explanatory.
Self –employed income Includes the income of all non farm businesses, other than
corporations (e.g. self-proprietors, and partners and also includes
The amounts for these categories in Canada, in 1997 (again in $ billions) were as follows:
Wages + Gross + Interest + Farmers’ + Self-employed = Net Domestic
Profits Incomes Income Income
446 80 47 2 58 633
To find the total incomes received by Canadians we need to make the following adjustment:
Net Domestic Income 633
+ / - net foreign investment income -28
= National Income 605
Reconciling GNP and National Income:
GNP calculations using the expenditure approach, and the total for national income using
the income approach do not agree. This is because not all receipts of businesses are paid out
in the form of incomes.
1) Firms must set up a fund for the replacement of worn-out capital. This is termed
depreciation (or capital consumption allowance) and is not available for distribution
either to employees or to shareholders.
GNP at market prices 828
- capital consumption allowance -110
= NNP at market prices 718
2) There is another item of income that firms receive but do not pay out as income to anyone, and
that is the amount of sales taxes (indirect taxes) which firms are required to collect on behalf of
NNP at market prices 718
- indirect taxes (net of subsidies) -113
= NNP at factor costs 605
It is important to note that there is a technical difference between GDP and Y, but that
conceptually, the two terms can be used interchangeably.
Personal Income & Personal Disposable Income
Personal Income: income paid to individuals before the deduction of personal income taxes.
Personal Disposable Income: the personal after-tax income of people.
Moving from national income to personal income in the national income accounting framework
requires four adjustments:
National Income 605
- undistributed corporation profits -25
- corporate profit taxes -29
+ government transfer payments 182
- other income not paid out -9
= Personal Income 724
- direct personal income taxes 200
= Personal Disposable Income 524
Problems in Measuring GDP
1) Economic transactions that are not included in the measurement of GDP are:
- the sale of intermediate goods (goods that will be used in the production of other final
goods and services);
- sales that merely transfer ownership of assets (the sale of stocks and shares);
- both public and private transfer payments; and
- the sale of second hand goods.
2) In the measurement of GDP, sales taxes are included as they are part of what consumers
actually pay for goods and services. Therefore, some people suggest that national income
(and not GDP) is a better measure of an economy’s performance because it excludes all
indirect (sales) taxes.
3) A number of items are excluded from the measurement of GDP even though they often
do represent real productive effort. These include the following:
- illegal activities;
- activities not reported to tax collectors (i.e. babysitting, and hairdressing);
- the value of the activities of a homemaker;
- do-it-yourself work; and
- voluntary work.
Non-market Activities are any economic activity that does not involve a payment (or the
payment received is not reported to Revenue Canada).
Part of the reason for the increase in the GDP over the years is that many services
that were once provided on a non-market voluntary basis, are now provided
commercially. Some examples include:
- commercial homemakers;
- day-care centres;
- interior decorators;
- gardeners, etc.