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