FOUNDATIONS OF MACROECONOMICS UNIT
CIRCULAR FLOW MODEL
IB CORE CONCEPTS AND NOTES SPECIFICALLY RELATED TO THIS VIDEO
IB Core Concept Standard Level and High Level Concept
Level of Overall Economic Activity The Circular Flow Model
• Explain, using a diagram, the circular flow of income between
households and firms in a closed economy with no government.
• Identify the four factors of production and their respective
payments (rent, wages, interest and profit) and explain that
these constitute the income flow in the model.
• Outline that the income flow is numerically equivalent to the
expenditure flow and the value of output flow.
• Explain, using a diagram, the circular flow of income in an open
economy with government and financial markets, referring to
leakages/ withdrawals (savings, taxes and import expenditure)
and injections (investment, government expenditure and export
revenue).
• Explain how the size of the circular flow will change depending
on the relative size of injections and leakages.
Source: IB Economics Subject Guide
Circular Flow of Income Model
▪ The circular flow model of income represents a very simple model for how a nation’s
economy works.
Circular Flow Model: Two-Sector Economy
▪ In this very simple model, there are two sectors: households and firms.
▪ Households:
o Are the people who buy the nation’s output of goods and services.
o Are the owners of all factors of production.
o Supply the factors of production to the firms and, in turn, receive payments for
their factors.
▪ Firms:
o Hire the factors of production from households.
o Use the factors of production to produce the nation’s output of goods and
services.
▪ Factors of Production and Factor Payments made simple…
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▪ This is the basis for the circular flow of income two-sector model.
▪ Households provide the factors of production (1) and receive income (2). They buy the
goods and services (3) produced by the firms by using the income received (4) and this is
the way the income circulates throughout the economy.
Circular Flow Model: Two-Sector Economy
Leakages and Injections
• Leakages
o Definition: In the circular flow of income model, refers to the withdrawal from
the income flow of funds due to savings, taxes or imports.
o Examples: consumer savings, taxes, buying imports.
• Injections
o Definition: In the circular flow of income model, refers to the entry into income
flow of funds due to investment, government spending, or exports.
o Examples: government spending, investment, purchase of exports
• Transfer payments
o Definition: Transfer payments are payments to individuals that are not the result
of an increase in output.
o Examples: pensions, unemployment benefits, child allowance payments.
o Governments tax the income of some households and transfer this income to
others through the payments.
→ As this is a transfer of income, and not an exchange for output, this spending
does not represent an injection.
Circular Flow Model: Four-Sector Economy
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▪ The economy stays in equilibrium where leakages are equal to injections.
▪ If leakages rise, without a corresponding increase in injections, then national output will
fall to a new equilibrium, as there will be less income circulating.
▪ If injections rise with no corresponding rise in leakages, then the economy will move to
a new equilibrium.
Source: Jocelyn Blink and Ian Dorton. IB Economics: Course Companion, Second Edition.