Neoclassical economics sees the macro economy as being very similar to microeconomics where equilibrium prices and levels of output are determined by demand and supply. The circular flow of income is a Keynesian macroeconomic model and it is very different to the neoclassical model.

We start with the simplest form of the model, imagine I spend £50 on a chair – let us call this expenditure. This expenditure of £50 must mean the chair is worth £50, so we can also say that the output of the economy is £50 because the value of what is bought must be the value of what is sold.

What happens to the £50 that firms receive from selling their output? They have to pay for the land, labour and capital they use to produce it, and if there is anything left over the entrepreneur gets a profit – so all of the £50 ends up with households one way or the other. What people earn is the same as the value of their output, which is the same as their expenditure - so now we can say that the value of expenditure, output and income are all the same. If we measure the economy by adding up what people earn it should equal the value of what retail sales are, and this should also be the same as the total value that each firm adds to a product as it goes through the chain of production.

The two-sector model
Another way of demonstrating the circular flow model is with a simple two-sector model. The two sectors consist of households and firms. Households provide to firms their land, labour, capital and enterprise and in return they receive rent, wages, interest and profit which together is the households’ income, lets use the letter Y to represent this.
The two-sector model is also seen in a slightly different version. Again we have households and firms – households spend their money with firms, which we call expenditure and we use the letter E for this. Firms give rent, wages interest and profit to households – together this is the households’ income and remember we use the letter Y for this – we use Y because later we will use the letter I for something else. The goods and services bought by households is the output and we give this the letter O.

However, the two-sector model is a poor representation of how things really are. We can make the model more realistic by showing that some money leaks out of the economy. When households earn income they don’t spend all of it – some goes into savings accounts or pension funds. These savings are deposited into the financial sector, so we now have a three-sector model. This model is sometimes known as the spendthrift model because everything that is spent is spent on consumption goods or E = C.

The three-sector model
Because E no longer = Y we need to change the model a little, expenditure is replaced with the word consumption and we use the letter C for this. Because consumption is less than income the economy will start shrinking – firms are getting less and can’t pay their workers as much so Y shrinks too – theoretically if people keep saving, their income will keep on falling too, and in the end their will be no spending and no income and with no income their will be no saving either – this situation was named by John Maynard Keynes as the paradox of thrift. The paradox is that if planned savings are greater than investment the economy shrinks, and with a shrunken economy, incomes shrink too, which means that actual savings will be much lower than planned savings. Keynes thought that saving was a good thing for individuals to do, but in a recession if everyone saved the recession would continue.

However, the money saved in financial institutions isn’t just left there, firms borrow from the banks and pension funds and invest in their businesses. Investment in economics means spending on capital goods such as new machinery, which is not the same thing as buying stocks and shares which is just a form of moving money about.

When firms invest in the economy, the economy expands and there is a corresponding increase in wages and salaries, so incomes increase, and because incomes increase then consumption increases too. Hopefully you should see that if investment is larger than planned savings the economy grows, and if planned saving is greater than investment the economy shrinks. At equilibrium where investment and savings are equal the economy is stable. We can now write an equation to show that aggregate demand equals the total amount of spending, AD = C + I.

The four-sector model
Of course the three-sector model is still a little simplistic. Not only do households save some of their income –some of it gets used to pay taxes.

By adding a fourth government sector we add another layer of complexity. If taxes disappeared down a black hole, the economy would shrink, just as it did if when savings were greater than investment in the three-sector model. However government spending is injected into the economy just as investment was.

in 1936 John Maynard Keynes (1888 – 1946) wrote that in a depression it was possible that planned savings would exceed investment and the economy would shrink and this would result in mass unemployment. Although there might be equilibrium in the goods and services market, the labour market could be in disequilibrium, where the supply of labour was greater than the demand. Keynes blamed depressions on a low level of aggregate demand. In this situation firms would lack confidence and be unwilling to invest so the problem would persist for a long time. The solution to the problem would be for the government to increase spending above the level of taxation. Increased injections would get the economy to grow. If necessary, the government would have to borrow the money to get the labour market back into equilibrium.

In the four-sector model the total amount of spending (aggregate demand) equals consumption, investment and government spending. AD =C+I+G.

The five-sector open model
So far our model has been a domestic model. By adding a fifth sector we open the model up to the world.

With the four-sector model savings and taxes leaked out of the system and into the financial and government sectors, and then were injected back into the circular flow in the form of investment and government spending.

With the addition of an overseas sector money leaks out of the system entirely as money is spent on imports, for which we use the letter M. Although the pounds that flow out will eventually flow back in as foreigners can’t do anything with these pounds other than buy something from us, they might not spend these pounds immediately. So in any time period there is no reason why money spent on imports should equal that earned from the sale of exports (X.) This complicates our formula a little because we must look at the spending on net exports (X-M).

In this final five-sector model expenditure (aggregate demand) is made up of consumption, investment, government spending and net spending on exports. Finally we arrive at one of the most important equations in economics.

AD = C+I+G+(X-M)

The money that flows out of the circular flow is called leakages or sometimes withdrawals (w). Investment, government spending and exports are collectively called injections and the small letter j is sometimes used. If planned injections are larger than planned withdrawals then the economy grows, but if planned withdrawals are larger than planned injections the economy shrinks. If planned injections and planned withdrawals are the same then actual injections and leakages will be equal too, and the economy neither grows nor shrinks.

The neoclassical economic model versus the Keynesian model
Neoclassical economics suggested that the macro-economy and the micro-economy were alike. If there was any unemployment then this was because there was disequilibrium in the labour market. If there were a surplus of labour, prices would fall and this would signal to firms to hire more people. With people now in jobs there would be enough money to buy everything that was produced – so the goods market and the labour market would always be in equilibrium – or as the French economist Jean-Baptiste Say said, “Supply creates its own demand”.

In 1929 the Great Depression, which had begun in the USA, spread around the world and there was mass unemployment almost everywhere except in communist states. John Maynard Keynes thought that the old neoclassical model had failed and he suggested another way of thinking about macroeconomics. It was possible for the goods and services market to be in equilibrium but at a level of demand that resulted in disequilibrium in labour markets. Even if the neoclassical model resulted in equilibrium in the long run it was no good Keynes thought because, “In the long run we are all dead”. Worse yet was the threat that mass unemployment brought politically. In Germany Adolf Hitler came to power partly on the promise of creating full employment and elsewhere people were looking also to fascism or communism for answers. So for Keynes it was necessary for governments to act to save capitalism. In 1936 in his most famous book, ‘The General Theory of Employment Interest and Money’, Keynes suggested that in depressions it was a low level of animal spirits that caused a lack of aggregate demand and unemployment. The answer was for governments to borrow and spend.


Keynesian – economic theories based on the ideas of John Maynard Keynes.

Expenditure – the total spent on goods and services, which is also the same as aggregate demand.

Income – the rent, wages, interest and profits that household earn.

Aggregate demand – the total level of expenditure in the economy C+I+G+(X-M).

Savings – income that is not spent.

Animal spirits – the amount of confidence people have in the economy, which effects their desire to spend and invest or to save.