June 2021

A leakage or withdrawal (W) is the money taken out of the circular flow of income. These real variables are the inputs (factors of production) and the outputs (goods and services). The inner circle is clockwise and is represented by green arrows in the above circular flow diagram. The government collects taxes and uses that revenue to provide essential public services. The government is foundational in supporting long-term economic growth by building infrastructure, maintaining law and order, and offering education and healthcare. Institutions serve as vital intermediaries in the financial landscape, ensuring the seamless movement of funds within an economy. If the government spends all its income received in the form of taxes, it flows back to the household and business sector in the form of subsidies and other government expenditures. Your expenses should always be lower than your income to have financial peace of mind. The firm then gives the money to their employees and workers in wages. Governments provide services to businesses, households, and foreign markets, and collect taxes to pay for these. Foreign markets buy and sell goods and services to and from our households, businesses, and governments. The flow of income and expenditure between the business sector and the government is similar. The government circular flow diagram in this template illustrates a 3-sector economy model. B2B H2H – Business to Business & Household to Household These flowsare indicated starting with the bottom yellow arrow in the circular flowdiagram below, through to the top orange arrow respectively. The rise of the digital economy has also introduced new challenges and opportunities, such as the growing importance of intellectual property, data, and e-commerce. These shifts have transformed conventional economic connections, giving rise to novel avenues for trading goods and services. Students of economics often point out a rather glaring flaw in the diagram wherein not all trade is between Households and Firms. The government also offers several finished goods and services in the market through SOEs and nationalized industries (e.g. utilities, banking services). Capital resources are goods used to produce other goods and services. Government Functions in the Circular Flow Model Thus, the government’s regulatory actions can shift economic resources and alter the equilibrium in the long term by changing the competitive landscape. These actions are instrumental in shaping the economic landscape, affecting everything from individual spending power to overall economic growth. The inner flow starts with the households that provide factors of production to firms through the factor markets. When firms get these factors of production, they use them to produce goods and services. These goods and services are sold by firms to households through the product markets. Leakages in the Circular Flow Model In the real-world there is a great deal of inequality, my article about the Gini-Coefficient discusses this in some detail. All people are consumersand all expenditure is done to maximize consumption i.e., to gain the maximum utility from thegoods and services that their incomes can afford. The CircularFlow Model uses one of the most well-known diagrams in economics to illustratehow income, expenditure, products, and inputs circulate through an economy. Itis one of the first concepts that will be introduced to students ofmacroeconomics. The Foreign Sector’s Role in the Circular Flow Model An increasingly significant market is the financial market were money is traded specifically for other currencies or financial profits. The circular flow model highlights the “flows” within the economy—the flow of economic resources, goods and services, and the flow of money. The government sector is composed of government owned institutes that regulate the economy. The government is also involved in spending money on public goods and many other projects. Taxes are leakages, and government spending on the economy is an injection. The leakages and injections are explained in the later part of this article. Saving (S) Government spending (G) is the spending of the government on public projects. Government spending is an injection and is the activity of the government sector. A part of the income earned by the government is saved and deposited in the capital market. The government also takes loans from the capital market either to meet the current expenditure or to invest in different projects. With the rise of the Global Economy, countries have also begun expanding the market to external forces. The economy becomes more complex when the government is added to the circular flow model. So, an entrepreneur might combine land, labor, and capital in new ways—taking risks along the way—to bring a good or service to market. Conversely, during periods of high inflation, the government might reduce its borrowing to avoid exacerbating the inflationary pressure. For example, at the diner, revenue comes from customers paying for their food. Taxes also remove money from the circular flow, though they are re-injected through government spending. Imports represent money leaving the domestic economy and flowing into foreign markets. The basic circularflow diagram illustrates how households provide inputs i.e., factors of production, tobusinesses in return for money. That money is then spent in the form ofconsumer expenditure, meaning that the money flows back to businesses, inreturn for which those businesses supply households with goods and services. Net exports (NX) is the difference between the value of exports and the value of imports. There isalso some controversy as to whether or not the banking and finance sectorshould be given special attention, and some of the standard economics textbooksdo not do so. Nevertheless, those same textbooks do give a great deal ofattention to saving and investment flows, so it pays to give a little extradetail for completeness. The mostobvious example of this would be people going to work, but it also includes landownersmaking their open for lease, and rental income. The foreign sector connects the domestic economy to the global market. Countries can export goods and services to international buyers, generating additional revenue and jobs. Imports allow access to foreign products, fostering competition and consumer choice. The government influences the flow of goods, services, and money by setting fiscal policies, funding