Circular Flow of Income

Above, we see a diagrammatical representation of the circular flow of income in the most basic two sector economy of households and firms.  In this model, the households give firms the factors of production (land, labor, capital and enterprise) and the firms take those FoPs, combine them in different ways, and return them to households as goods and services (inner blue circle).  To pay for these goods and services, households pay the firms through spending (expenditure).  In return, the firms pay the households for their FoPs in wages (for labor), rent (for land), interest (for capital) and profit (for enterprise).  This is shown by the outer black arrows.

Money can enter (injections) and leave (leakages) the circular flow.  The three purple arrows show the three basic injections: investment (I), government spending (G), and exports (X).  When firms spend money to add to the capital stock of the economy, that causes an injection of funds into the flow.  Similarly, governments spend for projects and programs which also puts money into the economy.  Lastly, when foreigners buy domestic g/s, that represents an injection into the circular flow of income. The three red arrows show the three basic leakages: savings (S), taxes (T), and imports (X).  Money leave the economy (or "leaks" out) when households put their money in banks for a later ("rainy") day, when the government takes out taxes from peoples' paychecks and when households buy foreign goods.  Another note: savings is required for investment (banks need money to lend) and governments spend with taxpayer money.