Money in an economy never sits still. It goes round in a loop: firms pay you, you spend it, and it lands back with firms. Once you can see that loop, almost everything else in macroeconomics is just a question of what makes the loop bigger or smaller.
📘 What you need to know
Households own the factors of production (land, labour, capital, enterprise) and sell them to firms. Firms pay income back.
Real things flow one way round the loop; money flows the other way.
Leakages (savings, taxes, imports) take money out of the flow.
Injections (investment, government spending, exports) put money back in.
If injections are bigger than leakages, national income grows. If leakages are bigger, it shrinks.
The same loop can be measured three ways — output, income and expenditure — and all three should give the same number.
GDP is the value of everything produced inside a country’s borders in a year.
Start with two players: households and firms
Strip the economy down to the bare minimum and you get two groups. Households are people like you. Firms are businesses. Households own everything a firm needs to produce: the land, the workers, the money for machinery, and the people willing to take the risk of running a business.
So households hand those resources over to firms. Firms use them to make things. And firms pay households for the privilege — wages for labour, rent for land, interest for capital and profit for enterprise. That payment is household income. Households then spend that income buying the goods and services the firms made, and the money is back where it started.
Notice the two green arrows are the same size. Total income paid out has to equal total spending, because every pound one person spends is a pound someone else receives.
Examiners love the phrase “one agent’s expenditure is another agent’s income”. If you can say that sentence and point at a diagram while you say it, you have understood the whole model.
Where money escapes: leakages
The two-player loop is too tidy. In real life you do not spend every penny you earn. Three things pull money out of the loop:
Savings (S) — money you put in the bank instead of spending it.
Taxes (T) — money the government takes before you get the chance to spend it.
Imports (M) — money you do spend, but it goes to a firm abroad, so it leaves this country’s loop.
These are called leakages or withdrawals. On their own they make the flow smaller: less spending means firms sell less, so firms hire fewer people, so income falls.
Where money returns: injections
Luckily, money comes back in from three matching sources:
Investment (I) — firms borrowing the savings and spending them on machines, factories and equipment.
Government spending (G) — the tax money coming back out as schools, hospitals, roads and public sector wages.
Exports (X) — foreign households buying things made here, so their money enters our loop.
Savings, taxes and imports pull money out. Investment, government spending and exports push it back in. What matters is which side is bigger.
Leakage (out)
Its matching injection (in)
What connects them
Savings (S)
Investment (I)
Banks take household savings and lend them to firms to spend on capital
Taxes (T)
Government spending (G)
The government collects tax and spends it back into the economy
Imports (M)
Exports (X)
We buy from abroad; foreigners buy from us
The size of the flow
If (I + G + X) > (S + T + M) → national income rises
If (I + G + X) < (S + T + M) → national income falls
They do not have to match. Savings do not automatically equal investment, and tax does not automatically equal government spending. That mismatch is exactly why economies boom and slump — and exactly why governments bother to intervene.
Three ways to measure the same loop
Look at the diagram again. If money is going round in a circle, you can stand at any point on the circle and count it. That is why national income can be measured three different ways, and why all three should land on the same number.
🧩 The three approaches
Output approach — add up the value of all the finished goods and services produced in a year.
Income approach — add up all the payments to factors of production: wages (W) + rent (R) + interest (I) + profit (P).
Expenditure approach — add up all the spending: C + I + G + (X − M). This is the one exam questions almost always use.
Nominal GDP, expenditure method
GDP = C + I + G + (X − M)
Be careful with what counts. Government spending here means spending on actual goods and services — teachers’ salaries, new hospitals, army equipment. It does not include transfer payments like pensions or unemployment benefit, because no new output is produced when that money moves. Similarly, income tax is a leakage, not a component, so it never goes into the GDP formula even when an exam table hands it to you.
WORKED EXAMPLE
Calculating nominal GDP from a data table
An economy reports the following for one year, in $ billions: consumption 480, investment 120, government spending 200, income tax 150, exports 90, imports 130. Calculate nominal GDP using the expenditure approach. [2]
Step 1: Pick out only what belongs in the formula
GDP = C + I + G + (X − M). Income tax is a leakage, so ignore it — it is there to catch you out.
Step 2: SubstituteGDP = 480 + 120 + 200 + (90 − 130)GDP = 800 + (−40)Nominal GDP = $760 billionnet exports were negative here, so they pulled GDP down
WORKED EXAMPLE
Will the circular flow grow or shrink?
In one year an economy records, in $ billions: savings 60, investment 90, taxes 140, government spending 150, imports 95, exports 70. Explain what will happen to national income. [4]
Step 1: Add up the injectionsI + G + X = 90 + 150 + 70 = 310Step 2: Add up the leakagesS + T + M = 60 + 140 + 95 = 295Step 3: Compare them310 − 295 = +15Net injection of $15 billion, so national income risesmore money going in than coming out, so firms sell more, hire more and pay out more income
Do not stop at “national income rises”. Finish the chain: more spending → firms produce more → firms hire more workers → incomes rise → those workers spend again. That last step is why one injection ends up raising income by more than the injection itself.
💡 Exam tip
Learn the pairs: S with I, T with G, M with X. If you can name the pair you can never mix up which side is which.
In a data table, cross out the numbers you do not need before you start. Income tax, net income from abroad and population are the usual distractors.
If a question says “explain”, you need a chain of at least three linked steps, not one sentence.
Watch the sign on net exports. If imports beat exports, (X − M) is negative and you subtract.
Government spending in the formula excludes pensions and benefits. Say so — it is an easy extra mark.
Size matters. A small rise in exports will not outweigh a large fall in consumption, because consumption is normally around 60% of AD.
⚠️ Common mix-up
Thinking savings are automatically invested. Banks may sit on savings in a downturn. That is precisely when the flow shrinks.
Putting income tax into GDP = C + I + G + (X − M). Tax is a leakage. It appears nowhere in the formula.
Calling imports “bad”. Imports leak money from the flow, but they also give households cheaper goods and firms cheaper inputs. Evaluate, do not judge.
Confusing investment with buying shares. In economics, investment means firms buying capital goods, not households buying financial assets.
Forgetting the diagram has two kinds of arrow. If you draw money and real resources going the same way, you have drawn it wrong.
Assuming the three measurement approaches are different things. They measure the same loop from three points; they should agree.
Up next: National Income Terms and Calculations — where we turn that loop into actual numbers, and learn why “nominal” GDP can lie to you.
Want this explained one-to-one?
Book a free session with an experienced IB Economics tutor and get your trickiest topics made simple.
