The circular flow of income and expenditure is the way money flows through the economy. There can be very simple flows, such as a household receiving income and buying goods and services that produce income for other households. Or there can be very complex flows involving savings and investments, governments and foreign trade.
A Household With No Savings
One example of the flow of income and expenditure is households. In a very simple economy, called a two-sector economy, households receive income for their work and spend it on goods and services that produce work for other families. So the Smith family, which receives income from marketing oranges, buys groceries, pays the mortgage, pays utility bills and makes a car payment. The money that goes to all of those companies would then pay those employees' salaries as well as buy products and services the companies use. When those employees receive their salaries, they buy goods and services, possibly including oranges, again putting money in the Smith family coffers.
Domestic Consumption With Savings and Investments
Because many people use part of their income not just to buy goods and services but also to save and invest, avenues are added to the circular flow. Part of the money goes from the Smith family to goods and services, and part goes to a savings account. Whether through savings in an investment retirement account or direct purchase of stocks, the family is now contributing to the flow through the financial markets. The companies whose stock it buys uses that money to buy more goods and services and hire more people, contributing to the circular flow.
Domestic Product Supply and Demand
Suppose that a certain music device was incredibly popular and people were purchasing it like crazy. This would create an increased flow of income and expense around the device, including many people being hired to produce the parts to make the device as well as to assemble, package and sell it. This also could lead to more investment in the device. If, however, demand dropped off a year later because of a new product, the flow of income would drop to a trickle. The income all along the circle reduces, leading to many people losing their jobs, including all those producing parts, assembling and selling the device. This also would lead to a surplus of devices, which may have to be sold at a discount.
Once you add governments into the mix, the circular flow becomes much more complex. Consider the production of oranges. The Smith family receives income from the sale of oranges -- not only from other households and businesses, but also from the government, which may buy the oranges for school lunches. In addition, foreign governments may purchase oranges from the company the Smiths work for. The Smiths use part of their income to pay taxes, which go to the government and help it buy more oranges and make investments in other companies. Also, the money the Smiths are saving at the financial institution might be borrowed by the government. That money may go to investment in the orange company or to the purchase of oranges or to other investments or products and services, such as the military.
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