How Does the Circular Flow of Income Work?

The circular flow of income shows how spending, output and income move between groups in an economy. Households buy goods and services from firms; firms use that revenue to pay households for the factors of production they provide, such as labour. This covers Cambridge International AS Level Economics Introduction to the circular flow of income: 4.2.1 (households, firms, government and the international economy), 4.2.2 (injections and leakages) and 4.2.3 (equilibrium and disequilibrium).

How the flow works

Households supply factors of production to firms and receive income, including wages. They spend some of that income on firms’ goods and services. Firms then have revenue from which to pay for production. Goods, services and factors of production flow in the opposite direction to the money payments.

A closed economy has no international trade. In an open economy, imports and exports connect the domestic flow to the rest of the world. Government also enters the model by collecting taxes and spending on goods and services.

Injections, leakages and equilibrium

An injection adds spending to the flow: investment by firms, government spending or exports. A leakage withdraws spending: saving, taxes or imports. If total injections equal total leakages, the flow is in equilibrium: there is no pressure from these flows for national income to change.

For example, suppose investment, government spending and exports are each $10$ million, while saving, taxes and imports are each $10$ million. Injections and leakages both total $30$ million, so the flow is in equilibrium. If injections rise above leakages, spending and income tend to rise; if leakages are greater, they tend to fall.

Common exam mistake: do not call saving an injection just because the money may later be invested. Saving is a leakage; investment is a separate injection.