The circular flow of income: problems with the model

As part of your Economics study, you’ve probably done the Circular Flow of Income Model. This is also known as the Five Sector Model or the Five Sector Circular Flow of Income Model. 

Here’s my explainer on the model. I’ve also written about how the Circular Flow of Income Model helps us understand economic growth.

The Five Sector/Circular Flow model is useful. I like it a lot, I use it all the time. But it’s not perfect. Here are some limitations you should be aware of.

A general limitation: The model heavily simplifies the economy

An economy is an extremely complicated thing. Can we really simplify something so complex into five sectors and 10 flows? 

Just think about the household sector. Do all individuals within households act in exactly the same way? What about firms, or financial institutions? It’s hard to lump all these groups into one category and assume they will all take identical actions.

In addition, central banks play a huge role in the economy. They affect the supply of funds, which then indirectly affects the level of interest rates (this is Monetary Policy). This is absent from the model.

A specific limitation: The model excludes households borrowing money from banks

Take a look at the financial sector, which includes banks. According to the model, households deposit their savings with the financial sector. 

But where is household borrowing?

The model does show the financial sector investing in businesses — lending firms funds so they can expand and grow. However, the model does not show households borrowing money from banks.

This is a huge flow in the economy. For example, according to the Australian Bureau of Statistics (ABS), in December 2021, households took out nearly $33 billion of new home loans — either to buy a property to live in or to rent out. This is a massive injection into the economy but is excluded from the model.

Likewise, household loan repayments — an ongoing leakage — are also absent.

Another specific limitation: The model excludes firms buying imports

The model shows households buying goods and services from overseas (imports). You can see the flow of money going from households to the international sector. Yet, the model does not show firms buying imports.

Just think about all the goods and services Australian businesses purchase from overseas:

• a restaurant purchases fancy cheese from Italy

• an outdoor recreation store (like Anaconda) purchases stock from overseas to then sell to local customers

• a school buys online products — such as access to the Google or Microsoft suite of products — and this involves money leaving Australia.

These purchases represent a huge flow of income. According to the ABS, in the September quarter of 2021, imports of capital goods (which are mainly done by businesses) totalled around $1.4 billion.

Do these limitations matter?

If we’re using this model to understand the basics of the economy, then no. It helps us understand the mechanics of how money moves around an economy and how the sectors interact with each other.

But like all models, it’s got limitations. We need to know its limitations so we don’t ask the Circular Flow of Income to do too much.

Scared consumers save more

Consumers can save or spend their income. This comes back to the identity Y=C+S.

Yes, consumers have to pay tax. And yes, consumers can use their savings to invest. The key part is that, when consumers receive their pay, they can either spend it now or put it away for later (savings/investment).

My point: the level of savings depends on consumer confidence, and consumer confidence is substantially affected by the economic outlook.

Let’s explain with the use of a graph.

The graph above comes from the Australian Bureau of Statistics from the June quarter national accounts 2021. 

Focus on the time frame from around June 2013 until June 2019. You can see that the household savings ratio varies between around 5ish to 9ish per cent (very precise!). This means that, on average, for every $1 of income households earn, they are saving somewhere between 5 and 9 cents. They’re generally spending MOST of their incomes.

Now focus on March of 2020 — see how the savings ratio spikes? This was the first wave of COVID-19 and consumer confidence plummeted. How did consumers respond? By saving a larger chunk of their incomes. In fact, in the June quarter of 2020, the household savings ratio rose to 22 per cent — meaning households were now saving 22 cents for every $1 they earned.

This all comes down to consumer confidence. When the economy is going well, consumers feel confident in the future. They feel confident to spend their money because they believe that the good times will continue and their ability to earn income, to continue spending, will, well, continue! 

(You could also think about how their marginal propensity to consume would be higher during ‘good’ economic conditions).

When consumers fear for the future, such as during the height of the first wave of the pandemic, they’ll reduce spending. They don’t know what the future holds. They want to hang on to their funds because they are unsure whether they can continue to earn the same level of income.

(You could think here about how the marginal propensity to save would be higher.)

I’ve annotated the above chart to summarise this info.

I think the household savings ratio is an extremely important statistic. It gives us, as economists, a good indication of consumer confidence. This also has implications for economic growth. This is because savings is a leakage and represents a withdrawal of funds from the economy. The higher the level of saving, the lower the level of consumption, which will put downward pressure on GDP.

I’ve also got a video on the topic you can check out below.

The Five Sector Model (Circular Flow of Income) and economic growth

The Five Sector Model* is a simplified model of how an economy works. It shows how money moves around an economy and involves five sectors only: households, firms, the financial sector, the government sector and the international sector. 

[*The Five Sector Model is also known as the Circular Flow of Income Model. Same same.]

If you’re new to the concept, I’ve got a video (below) and you can read more about it here.

In terms of the Five Sector Model, we have injections (money flowing into the economy) and leakages (where money leaves the economy). 

The injections are Investment (I), Government Spending (G) and Exports (X). The leakages are Savings (S), Tax (T) and Imports (M). 

Let’s look at the relationship between injections and leakages.

When the value of injections EQUALS the value of leakages, the economy is in a state of equilibrium. The economy is neither growing nor slowing; it’s stable.

When the value of injections EXCEEDS the value of leakages, the economy is growing. More money is flowing into the economy than is leaving. As a result, gross domestic product (GDP) is likely rising, unemployment is likely falling and prices are probably on their way up (higher inflation).

When the value of leakages EXCEEDS the value of injections, the economy is slowing. More money is being removed (or withdrawn) from the economy than is being pumped into it. As a result, GDP is likely falling, unemployment is on the rise and prices and probably dropping (lower inflation).

Let’s take an example question. This is Q14 from the 2017 NSW HSC Eco exam.

Source: NESA

If we do the quick maths, we can see that injections equals 115 and leakages equals 125. So this would indicate the the economy is contracting — our answer would be D.

We can also use the Five Sector Model to talk about the budget balance and the trade balance, but we’ll leave this for another post. (For a headstart, check out Q9 from the 2019 HSC Eco exam.)

The five sector model (aka the circular flow of income)

Economics can be an incredibly complicated discipline. We do our best to simplify things at times. This is the case with the five sector model, also known as the circular flow of income. 

(In this blog I’m going to call it the five sector model. Both terms are correct.)

With the five sector model, we take the entire complicated, messy and interconnected economy...and we simplify it into just five sectors. These are:

• The household sector (essentially individuals in the economy)

• The firms sector (businesses, companies — this kind of thing)

• The financial sector (think: banks)

• The government sector (ah, governments)

• The international or overseas sector (an economy’s interactions with other economies).

This is what the model looks as a whole (below). But I think the best way to understand this is to start small and build up.

The five sector as a whole.

Step one: The two sector model

In this model, we just have households and firms. We have simplified the economy enormously!

Households supply firms with resources (such as labour). Then, firms supply households with wages in exchange for their labour.

Another flow is that households purchase goods and services produced by firms. So firms provide households with goods and services, and households buy these goods and services (known as consumption).

Step two: The three sector model

We now add the financial sector. 

Households deposit their savings with the financial sector. The financial sector then lends these savings to firms to help them grow and expand (this is known as investment).

Step three: The four sector model

We now include the government into our simplified model of the economy.

Governments collect taxes from households (so, households pay tax to the government). The government then spends money in the economy in many ways, including unemployment benefits and infrastructure spending. As a whole, this is called government spending. 

Step four: The five sector model

Now, we include other economies (from other countries). This is called the international or overseas sector. 

Let’s say we’re talking about the Australian economy. Households buy goods and services from overseas. These are called imports and involve money leaving Australia. Then, Australian firms sell goods and services overseas. These are called exports and involve money flowing into Australia.

A little extra

When we talk about the five sector model, we discuss money flowing into the economy (injections) and money leaving the economy (leakages). I discuss this in detail in the video below, but here’s a summary table that can help. You can also read on about the five sector model and variables such as economic growth, unemployment and inflation.