What Is the Leakage Out of the Circular Flow of Income?

The economy has a circle life much like nature. Money flows in a circular manner through consumers and businesses in an ideal system, but in reality all flows of income have leaks. Tracking the flow of money and finding leaks may help small businesses plan for significant policy changes and anticipate how the government may try to balance its budget.

In a closed circular income stream, money flows continuously from firms to households. Households spend all of their money on goods and businesses spend all of their money on labor and expansion. The basic model of the circular flow of income ignores common consumer actions that take money out of the circular of income, or leakage. For instance, most households save money and some companies retain earnings.

Net taxes are the second largest cause of leakage in the circular flow of income in a system closed off from the rest of the world. Income taxes, property taxes and payroll taxes go directly to the government. However, the government frequently injects taxes back into the circular flow of income. For instance, government pays billions of dollars each month in pensions and Social Security checks. The government also spends tax dollars on projects for the public good, such as parks and roads.

Ultimately, a government must balance its leaks with inflows of cash. This often happens by increasing exports or borrowing money from foreign governments and investors. In some cases, such as with the United States during the 1990s and '00s, a government depends entirely on foreign investment. For instance, imports grew from 1 percent to 6 percent of total domestic production between 1991 and 2005. In addition, the government spent more than it received in taxes. The only way the U.S. could balance leakage in the economy was to acquire foreign investment.

Small businesses should pay attention to key monetary metrics, such as government spending, consumer confidence and interest rates. For instance, if the government wants consumers to purchase more goods and inject money into the economy, it often lowers interest rates so consumers can purchase goods on credit. If the government wants to lower its deficit, it may raise taxes on businesses or eliminate some spending programs.