The five sector circular flow of income model describes the operation of an economy and the linkages between the main sectors in an economy. The model divides the income to five sectors; the individuals, Businesses, financial institutions, governments and international trade and financial flows.
The individuals consist of all individuals in the economy and looks at their activities such as earning income and spending it on goods and services. They supply factors of production (inputs) such as labour and enterprise to businesses who then produce goods and services. Individuals then receive incomes as rent, wages, interest and profits.
It is important to think of the individuals sector and the business firms together as together they affect the amount of economic activity in a circular flow of income. The businesses buy factors of production and use them to sell goods and services. They are dependent on individuals, as their spending becomes their income to then spend on producing the goods and services in demand for the consumers. Individuals and businesses are interdependent they are both needed to exist.
The institutions involved in the borrowing and lending money of money are the financial institutions sector. They act between the savers and borrowers of money and consist of; banks, building societies, finance companies, credit unions, superannuation funds and life insurance companies. It enables individuals and businesses to both save and borrow money. The financial institutions mobilise savings so they can be used for investment.
In the circular flow of income savings are leakages as it is money withdrawn causing a reduction in both the circular flow of income and in economic activity. The leakage of savings causes a fall in expenditure on goods and services, a fall in production, a fall in the demand for resources and a fall in income to the owners of those resources. To counteract the leakages of savings there are injections of investment.
Investment is any current expenditure that is made in order to obtain benefits in the future. Investments represent an injection into the circular flow and have the opposite effect of a leakage. Spending on investment would lead to rising expenditure, production, employment and income levels in the economy. The individuals, businesses and financial institutions make up the private sector of our economy.
The government sector consists of the Commonwealth, state and local. They are responsible for collective (community) wants and obtain resources by imposing taxes on the other sectors of the economy. The government then uses tax revenue to undertake government expenditure. Taxation is a leakage in the economy and causes a reduction in the level of economic activity. Government expenditure represents an injection as it goes towards collective goods and services. The sector is our public sector and together with the private sector makes up the domestic sector in our economy. International trade and financial flows cover all transactions that our economy has with the rest of the world. This includes exports, imports and international money flows. Imports are goods and services produced overseas but sold in Australia and these payments represent leakages from the circular flow. Exports are goods and services produced in Australia but sold overseas to overseas customers and increase the size of the circular flow, as they are injections.