The 5 sector circular flow model

• Disposable income

  Income households have available after paying taxes and receiving transfers
• The circular flow of income

  1. Describes the flows of money among the five main sectors of an economy

  2. Money flows among the different sectors of an economy as individuals and firms buy and sell goods and services

  3. Gross domestic product (GDP) = income = production = spending
• Investment refers to the purchase of goods and services that help produce more output in the future
• Consumption spending of households

  In return for the goods and services that flow from firms to households
• Components of the circular flow

  • Consumption
  • Investment
  • Government purchases
  • Net exports
• Household budget constraint

  Disposable income = consumption + household savings
• Government purchases include all purchases of goods and services by the government
• Net exports measure the expenditure flows associated with the rest of the world
• National income identity

  Production = consumption + investment + government purchases + net exports
• The relationship GDP = income = production = spending lies at the heart of macroeconomic analysis
• There are two sides to every transaction
• Government sector

  Summarizes the actions of all levels of government in an economy
• Consumption refers to total consumption expenditures by households on final goods and services
• Wage income received by consumers

  In return for labor services that flow from households to firms
• Household sector

  Summarizes the behavior of private individuals as consumers/savers and suppliers of labor
• When the government is running a surplus

  There is a flow of dollars to the financial markets from the government sector
• Government purchases + transfers = tax revenues + government borrowing

  Government budget constraint
• Borrowing from other countries = imports − exports = trade deficit

  Trade deficit
• When the government is running a deficit

  There is a flow of dollars to the government sector from the financial markets
• Flows from the household sector must balance

  The Government Sector
• Positive current account


  Our economy is lending to the rest of the world and acquiring more assets
• Foreign Sector

  • Includes a country’s dealings with the rest of the world
  • Flows include exports, imports, and borrowing from other countries
  • Net exports are exports minus imports
  • Borrowing and lending between countries
• Government Sector

  • Summarizes the actions of all levels of government in an economy
  • Governments tax their citizens, pay transfers to them, and purchase goods from the firm sector of the economy
  • Governments borrow from or lend to the financial sector
  • Government collects taxes, pays for government purchases and transfers, and may borrow to make up shortfalls
• If a country runs a trade surplus

  It is lending to other countries
• Financial Sector

  • Summarizes the behavior of banks and other financial institutions
  • Investment is financed by national savings and borrowing from abroad
• If a country runs a trade deficit

  It borrows from other countries to finance that deficit
• The financial sector is at the heart of the circular flow
• Government borrowing is sometimes referred to as the government budget deficit
• Borrowing from other countries + exports = imports

  Trade deficit
• Income flows from assets acquired or paid to other countries are added to the trade surplus/deficit to give the current account of the economy
• Government surplus


  Government revenues are greater than expenditures, leading to a flow of dollars into the financial sector
• Households

  1. Divide their after-tax income between consumption and savings

  2. Income put aside for the future is sent to the financial markets

  3. Household sector saves, leading to a flow of dollars from households into financial markets
• Calculation of national savings

  • Private savings minus government borrowing
  • Private savings plus government surplus
• Financial sector to firm sector

  Provides funds available to firms for investment purposes
• Flow of dollars between financial sector and foreign sector

  • Can go in either direction
  • Positive net exports mean lending to other countries, negative net exports mean borrowing from other countries
• Lending to other countries


  National savings divided between investment and lending to other countries
• National savings is the amount that an economy as a whole saves, equal to what is left over after subtracting consumption and government spending from GDP
• Investment


  Financed by national savings and borrowing from abroad
• Financial sector to government sector

  1. Reflects the borrowing (or lending) of governments

  2. Flow can go in either direction
• If borrowing from other countries, there is another source of funds for investment