Leakages in the Circular Flow

To complete our understanding of circular flow, lets now learn about leakages from the same. 3 new entities will now be introduced into the circular flow to explain how they create leakages.
leakages-cf-chart1.Introducing Government

The first entity that is being introduced is Government and it is at the center of the circular flow. Government collects taxes from both individuals and firms. A part of the money received by individuals in factor market, in exchange for land, labor and capital, will be collected by the government as tax. Similarly, a part of the money received by firms in return for finished goods will be collected by the government as corporate tax. Government collects taxes so that the amount can be spent for public welfare by creating public goods. Public goods are goods and services available and useful to all members of the society. This usually includes roads, ports, railways, schools & colleges, hospitals etc.   

2.Introducing External Sector

External sector is linked to the finished goods market. Foreign entities buying finished goods manufactured in a country, say India, i.e. exports, results in injection of money into the economy. Similarly, Indians buying foreign finished goods, i.e imports, results in money flowing out of the economy.

3.Introducing Financial Sector

Financial sector is linked to the factor market. In our previous article, we mentioned that expenditure by firms on capital items like machinery, tools and technology in factor market results in interest income for households. Households earn rent and wages from factor market. A part of this earning is saved in banks for future needs and only remaining balance is spent in finished goods market. This act of saving, results in a leakage and money flows out of the circular flow. Firms borrow money from banks in order to fund their capital related expenditure. This way money is again injected into the economy and in the process firms pay interest to banks for borrowing money. Banks pass on some part of that interest earned to households, in return for parking their funds. Thus households are saving funds and depositing the same in banks. This kitty is then lent out by banks to firms, to fund their capital needs. So in a roundabout way households enable firms to buy capital and in the process earn interest. Banks facilitate the entire process.

Now that our understanding of circular flow is complete, we can easily use the same to learn how GDP is measured in any economy.