How income flows between households and firms, injections and withdrawals, and why national income changes when they are unequal. Through saving in 2020.
During the first lockdown, the UK household saving ratio, the share of disposable income saved, jumped to its highest level since records began, as households could not spend on holidays, meals out and many shops. Spending collapsed, and with it firms’ revenues and many people’s incomes. Furlough payments kept household incomes flowing.
How does one person’s saving become another person’s lost income?
Source: Office for National Statistics, household saving ratio (2020).
The circular flow of income shows how money moves around the economy. Households own the factors of production and sell them to firms. Firms pay them income: wages, rent, interest and profit. Households spend that income on firms’ goods and services: consumption.
Some income leaks out: these are withdrawals, saving, taxes and imports. Some spending comes in from outside: these are injections, investment, government spending and exports.
The model assumes we can group everyone into households and firms, with banks, government and other countries as the sources of withdrawals and injections.
During the 2020 lockdowns, UK households saved far more than usual.
They had fewer chances to spend, and many were worried about the future.
What does more saving do to the flow of spending around the economy?
Saving is income that is not spent, so it leaks out of the flow of spending. Unless something is injected to replace it, such as government spending, the flow of income shrinks. In 2020 furlough payments propped up household incomes, so spending fell by less.
Firms pay households incomes for their labour, land, capital and enterprise. Households spend it on firms’ output. One group’s spending is the other’s income. National income, output and expenditure are three ways of measuring the same flow.
Some income is not spent on UK firms’ output. It is saved, paid in taxes or spent on imports. These are withdrawals: they leak out of the flow.
Check: Which of these is a withdrawal?
Taxes take income out of the flow before it can be spent. The others are injections.
And some spending on UK output does not come from households’ consumption: firms’ investment, government spending and foreign buyers’ spending on our exports. These are injections.
National income is in equilibrium when injections equal withdrawals. If injections are bigger, national income rises; if withdrawals are bigger, it falls. That is what happened in 2020: saving rose and exports and investment fell, so national income fell. Furlough payments and higher government spending cushioned the fall.
Check: Injections are £800bn and withdrawals are £840bn. What happens to national income?
More is being withdrawn than injected, so the flow of income shrinks.
Now suppose every household tries to save more at the same time.
Check: Every household tries to save a bigger share of its income at the same time. What is the most likely result?
Saving more means spending less, and one person’s spending is another’s income. As incomes fall, people can afford to save less, so total saving may end up barely higher.
Saving is not bad for the economy in the long run: it funds investment. But if everyone saves more at once, spending and incomes fall, and they may end up no better off: the paradox of thrift.
Exports are an injection: foreign buyers spend money on UK output, adding to the flow. Imports are the withdrawal.
Explain why national income may fall if withdrawals are greater than injections.
In the circular flow of income, firms pay incomes to households, who spend them on firms’ output. Some income is withdrawn from the flow, through saving, taxes and spending on imports, and some spending is injected from outside, through investment, government spending and exports.
If withdrawals are greater than injections, more is leaking out of the flow than is being added. Less is spent on UK output than households earn, so firms’ revenues fall. Firms respond by cutting output and employment, which reduces households’ incomes.
National income keeps falling until, at the lower level of income, withdrawals have fallen enough to equal injections again. For example, the sharp rise in saving in 2020 was a rise in withdrawals that contributed to the fall in national income.
However, the size of the fall depends on how much of each pound of lost income is withdrawn: because saving, taxes and imports fall as income falls, national income settles at a new, lower equilibrium rather than falling indefinitely. The government can also offset the gap by injecting more, as furlough payments and higher government spending did in 2020.
UK household saving ratio: Office for National Statistics (2020). Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed. Your answers are saved only on this device.