ECON2: The National Economy

2.3 Circular Flow of Income

How does money move around the economy?In what ways can this flow of money increase?In what ways might this flow decrease?

2.3 What you need to know

The concept of the circular flow of incomeHow the circular flow of income might

become larger or smallerThe equation income = output = expenditureThe term macro-economic equilibrium

2.3 You should be able to:

Understand and illustrate the concept of the circular flow of income on a diagram

Identify the different injections and withdrawals that might impact the size of the circular flow of income

Understand and explain why income = output = expenditure

Explain clearly the concept of macro-economic equilibrium

The Circular Flow of Income: A Definition

“An economic model showing the flow of goods and services, the factors of production and their payments between households and firms within an economy.”

Imagine you spend £10 in a shop, where do you think it goes?

Draw a flow chart of how you think that £10 may spread around the economy.

A Simple ModelThe UK economy is very complex and operates in a

global environment, so initially we are going to simplify the model

We are going to assume the economy is “closed”

This means there is no foreign trade and no government influence

This means there are only 2 groups1. Households2. Firms

A Simple Circular Flow of IncomeHouseholds

Firms

1) Firms provide

households with goods

and services

4) In order to pay for these

factor services, firms

pay households rent, wages, interest and

profit

2) Households spend their

income on the goods and services

produced by firms

3) Households also provide

firms with factors of production: Land, Labour,

Capital & Entrepreneurshi

p

Key Terms

Land = For buildings Labour = For output Capital = For investment

Rent = For Land Wages = For Labour Interest = For Capital Profit = For Entrepreneurship

Assumptions

This simple model makes a number of assumptions1. Households spend all their income on goods and

services2. Firms spend all their income on factors of

production3. There is no government4. There is no foreign trade

THIS IS CLEARLY UNREALISTIC – WHY?

A More Realistic Model

We need to take into account a more realistic role of all the participants in the circular flow

To do this we consider INJECTIONS into and WITHDRAWALS from the circular flowDo you think the following are injections or

withdrawals from the circular flow of income?Savings Investment

Exports Government Spending

Taxes Imports

A More Realistic Model

Households

Firms

INJECTIONS

Government ExpenditureInvestment

Exports

WITHDRAWALS

SavingsTaxes

Imports

For each of the following examples, decide whether the circular flow of income will increase or decrease in size

Event Increase or Decrease

The rate of VAT increases

Tax breaks are given to new start-up businesses

The pound strengthens against the Euro

Interest rates are cut

Workers become nervous about keeping their jobs

Measuring National Income

There are three different methods of calculating the level of national income in an economy

1. Income Method2. Output Method3. Expenditure Method

Measuring National Income In theory, these 3 methods will always equal each other

Example: If a firm produces a unit of output and sells it for £100, it

can be said that the value of that output is £100

Therefore, it follows that the firms income will be £100

Logically, it must also follow that the customer has provided £100 of expenditure

Therefore: income = output = expenditure

Macroeconomic Equilibrium

This will be covered in 2.4 in more detail Macroeconomic equilibrium occurs when

the demand-side of the economy and supply-side of the economy equal each other

This means that everything that has been produced by firms, has been purchased and consumed by households

In macro-economic equilibrium there is no excess demand or excess supply

Multiple Choice 1

Which combination of the following are withdrawals from the circular flow of income?a) Government spending, Imports, Taxesb)Savings, Exports, Taxes c) Savings, Imports, Taxesd)Imports, Exports, Saving

Can you explain your answer?

Multiple Choice 2

Which of the following is most likely to cause an increase in the size of the circular flow of income? An increase ina) investmentb) tax revenuec) importsd)saving

Can you explain your answer?

2.3 You should be able to:

Understand and illustrate the concept of the circular flow of income on a diagram

Identify the different injections and withdrawals that might impact the size of the circular flow of income

Understand and explain why income = output = expenditure

Explain clearly the concept of macro-economic equilibrium