Relation between Leakages and Injections in Circular Flow

Injections Leakages Model

A macroeconomic model that balances non-consumption expenditures on production (injections) and non-consumption uses of income (leakages) that is used to identify the equilibrium level of, and analyze disruptions to, aggregate production and income. The injections-leakages model is based on the principles of Keynesian economics and provides an alternative to the standard aggregate expenditures (Keynesian cross) analysis. The three injections included in the model are investment expenditures, government purchases, and exports. The three leakages included in the model are saving, taxes, and imports. Three variations are the two-sector injections-leakages model (or saving-investment model), three-sector injections-leakages model, and four-sector injections-leakages model.

The injections-leakages model provides an alternative to the more common Keynesian cross, aggregate expenditures-aggregate production model of the macroeconomy. Both models provide essentially the same analysis and are essentially “two sides of the same coin.” The key difference between the two models is that consumption is explicitly eliminated from the injections-leakages variation. Whereas the Keynesian cross builds on the consumption function, the injections-leakages model builds on the saving function’,500,400)”>saving function.

Injections and Leakages

One half of the injections-leakages model is injections, which are non-consumption expenditures on aggregate production. The three injections are investment expenditures, government purchases, and exports. These are termed injections because they are “injected” into the core circular flow of consumption, production, and income.

The other half of the injections-leakages model is leakages, which are non-consumption uses of the income generated from production. The three leakages are saving, taxes, and imports. These are termed leakages because they are “leaked” out of the core circular flow of consumption, production, and income.

Equilibrium in the injections-leakages model relies on a balance between the injections into the core circular flow and leakages out of the flow. If leakages match injections, then the volume of the core circular flow does not change. This is the same as achieving a balance between the water flowing form a faucet into a sink and that flowing out through the drain. When these two flows are equal, then the total amount of water IN the sink does not change.

The Circular Flow

Injections and leakages can be best illustrated using the standard circular flow model of the macro economy, such as that presented in the exhibit to the right. The circular flow is a handy model of macroeconomic activity that highlights the interaction between households and businesses through the product and resource markets.

The business sector is at the right and the household sector is at the left. The product markets are at the top and the resource markets are at the bottom. The household sector buys production from the business sector through the product markets. Expenditures by the household sector are consumption expenditures. Revenue going to the business sector is gross domestic product.

The business sector hires factor services from the household sector through the resource markets. Payments made by the business sector are factor payments. Income going to the household sector is national income.

These four parts — consumption expenditures, gross domestic product, factor payments, and national income — are the core of the circular flow. They are the “engine” that drives the macroeconomy.

Let’s now consider how injections and leakages relate to this core circular flow.

• Injections: The three injections — investment, government purchases, and exports — can be displayed by clicking the [Injections] button. These injection expenditures, like consumption, are used to purchase aggregate production through the product markets. Most importantly, injections add to the total volume of the basic circular flow. That is, they “inject” revenue into the product markets that is used for factor payments and becomes household income.
• Leakages: The three leakages — saving, taxes, and imports — can be displayed by clicking the [Leakages”] button. These leakages, like consumption, are how the household sector divides up or uses its income. Most importantly, leakages subtract from the total volume of the basic circular flow. That is, they “leak” income away from the product markets, making less available for factor payments and household income.

The critical implication from the circular flow is that a balance between injections and leakages maintains a constant flow of income, consumption, production, and factor payments moving between the household and business sectors. This is the essence of macroeconomic equilibrium — the level of aggregate production remains unchanged.

However, if injections exceed leakages, then the volume of the basic flow expands and aggregate production increases. Alternatively, if leakages exceed injections, then the volume of the basic flow contracts and aggregate production decreases. As we shall see, this change in production is what moves the economy to an equilibrium balance.

The Injections-Leakages Balance

A balance between injections and leakages generates the same equilibrium as a balance between aggregate expenditures and aggregate production. A little manipulation of the Y = AE equilibrium condition illustrates why.

(i) Aggregate expenditures (AE) are the sum of consumption (C), investment (I), government purchases (G), and net exports (X – M).

AE = C + I + G + (X – M)

(ii) The income generated by aggregate production (Y) is used by the household sector for consumption (C), saving (S), and taxes (T).

Y = C + S + T

(iii) Substituting each of these equations into the Y = AE equilibrium condition gives us:

C + S + T = C + I + G + (X – M)

(iv) Because consumption (C) is on both sides, it cancels out.

S + T = I + G + (X – M)

(v) For reasons that will be apparent later, let’s move imports (M) to the left-hand side.

S + T + M = I + G + X

This last equation indicates that equilibrium can be achieved by equating injections I + G + X with leakages S + T + M. Most importantly, when aggregate expenditures equal aggregate production (Y = AE), then injections are necessarily equal to leakages S + T + M = I + G + X.