Injections and Leakages in the Four-Sector Flow

Idea

Extending the circular flow to four sectors adds the government and the foreign sector alongside households and firms, and with them two new kinds of flow: injections, which add to the flow of income, and leakages (withdrawals), which drain from it.

Mechanism

Money leaves the domestic circular flow as a leakage whenever income is not passed on to domestic firms as expenditure. There are three:

• Saving (S) — income placed with banks rather than spent;

• Taxation (T) — income taken by the government;

• Imports (M) — expenditure that flows to foreign rather than domestic producers.

Money re-enters as an injection — expenditure on domestic output that does not originate from domestic households’ current income. Again three, matching the three leakage destinations:

• Investment (I) — firms’ spending on capital goods, funded from banks;

• Government spending (G) — the government’s expenditure on domestic output;

• Exports (X) — foreign spending on domestic output.

Leakages cause the flow of income to contract; injections cause it to expand. The economy is at equilibrium when the two are equal, so that the flow neither grows nor shrinks:

$\text{Injections } (I + G + X) = \text{Withdrawals } (S + T + M)$

An imbalance sets off an adjustment: when injections exceed withdrawals, income rises through the multiplier effect until withdrawals rise to match.

Diagram