The Five Sector Model (Circular Flow of Income) and economic growth

The Five Sector Model* is a simplified model of how an economy works. It shows how money moves around an economy and involves five sectors only: households, firms, the financial sector, the government sector and the international sector.

[*The Five Sector Model is also known as the Circular Flow of Income Model. Same same.]

If you’re new to the concept, I’ve got a video (below) and you can read more about it here.

In terms of the Five Sector Model, we have injections (money flowing into the economy) and leakages (where money leaves the economy).

The injections are Investment (I), Government Spending (G) and Exports (X). The leakages are Savings (S), Tax (T) and Imports (M).

Let’s look at the relationship between injections and leakages.

When the value of injections EQUALS the value of leakages, the economy is in a state of equilibrium. The economy is neither growing nor slowing; it’s stable.

When the value of injections EXCEEDS the value of leakages, the economy is growing. More money is flowing into the economy than is leaving. As a result, gross domestic product (GDP) is likely rising, unemployment is likely falling and prices are probably on their way up (higher inflation).

When the value of leakages EXCEEDS the value of injections, the economy is slowing. More money is being removed (or withdrawn) from the economy than is being pumped into it. As a result, GDP is likely falling, unemployment is on the rise and prices and probably dropping (lower inflation).

Let’s take an example question. This is Q14 from the 2017 NSW HSC Eco exam.

If we do the quick maths, we can see that injections equals 115 and leakages equals 125. So this would indicate the the economy is contracting — our answer would be D.

We can also use the Five Sector Model to talk about the budget balance and the trade balance, but we’ll leave this for another post. (For a headstart, check out Q9 from the 2019 HSC Eco exam.)