What are the leakages in the circular flow model?

The three leakages in the circular flow model are saving, taxes, and imports (money that leaves the domestic spending stream instead of flowing straight back to firms). Each leakage has a matching injection: investment, government spending, and exports, the corresponding inflows of new spending from outside the household-firm loop. A full circular flow diagram adds a financial system, a government sector, and a foreign sector to the basic two-sector model precisely to show where this money exits and re-enters.

Saving is the first leakage. When a household earns income and does not spend all of it on goods and services, the unspent portion goes into banks, bonds, or other financial assets rather than back to firms as consumption spending. That saved money does not disappear from the economy: it flows into the financial system, which lends it out to firms that want to borrow for capital projects. This lending is what turns saving back into investment, the injection that offsets it.

Taxes are the second leakage. Households and firms pay part of their income to government instead of spending or investing it directly, so that money exits the private circular flow the moment it is collected. It returns as an injection when government spends it: on salaries for public employees, infrastructure projects, and public services. Transfer payments such as Social Security and unemployment benefits are not part of this injection, since they flow directly back to households rather than paying for newly produced goods and services. Government spending is the injection that matches the leakage of taxes, and the two flow through the public sector rather than through banks.

Imports are the third leakage. When a household or firm buys a good or service made abroad, that spending leaves the domestic economy and goes to a foreign producer instead of circulating back to domestic firms. The matching injection is exports: spending by foreign households and firms on domestically made goods and services, which brings money into the domestic economy from outside. Net exports, exports minus imports, is the single line where this leakage and this injection usually appear together on an AP Macro graph or table.

Equilibrium in the circular flow model requires total leakages to equal total injections: saving plus taxes plus imports must equal investment plus government spending plus exports (S + T + M = I + G + X). When leakages exceed injections, less money flows back into firms than is exiting the loop, spending contracts, and real GDP falls. When injections exceed leakages, more money enters the loop than exits it, spending expands, and real GDP rises. Only when the two sides balance does aggregate spending, and output, stay steady from one period to the next.

A typical free-response question gives you a set of values and asks whether the economy is in equilibrium. Suppose saving is 200, taxes are 150, and imports are 100, so total leakages equal 450, while investment is 180, government spending is 170, and exports are 100, so total injections also equal 450. Because leakages equal injections, the economy is in equilibrium and real GDP has no tendency to change. If imports rose to 150 with nothing else adjusting, leakages would exceed injections by 50, and you would explain that spending, and output, contract until a new equilibrium is reached.