Circular Flow of Income

Lesson Objectives

• To understand what the circular flow of income is• To learn what it contains• To understand why we measure nations’ (flow of)

income• To appreciate that wealth and income are not

the same

The circular flow of income

Firms

Households

Rent,wages,interest and profit

Expenditure on goods and services

Goods and

services

Land, labour and

capital

This is a simple model – a CLOSED economy – where there is no foreign trade

The circular flow of income

Firms

Households

Rent,wages,interest and profit

Expenditure on goods and services

Goods and

services

Land, labour and

capital

Based on this model, there are three ways of measuring the level of economic activity

Measuring the level of Economic Activity

• National Output (O) – the value of the flow of goods and services from firms to households

• National Expenditure (E)– the value of spending by households on goods and services

• National Income (Y) – the value of income paid by firms to households in return for land, labour and capital

O E Y

Injections and Withdrawals

• The circular flow of income highlights the main injections and withdrawals in an economy.

• Injections will add money to the circular flow of income; they raise spending.

• Withdrawals will remove money from the circular flow; they reduce spending.

Injections and Withdrawals

Households

InjectionsInvestment

Government SpendingExports

Firms

WithdrawalsSavingTaxes

Imports

Income Expenditure

What does this all mean?

• If injections are greater than withdrawals, expenditure on goods and services will exceed the planned level of production. Firms will, therefore, expand output and national income will rise.

• However, if withdrawals are greater than injections, production will exceed the current level of expenditure. Firms will, therefore, reduce their output and national income will fall.

Measuring National Income

• Different measures are used to calculate national income

• The best known measure is GDP• This increases the actual value of national

income because it includes indirect taxes such as VAT

• There are other measures of national income, but GDP remains the best guide to economic performance both over time and between countries

Activities

• Questions 1 (a) and (b) on page 162• Questions 3 (a) and (b) on page 163

Question 1: p.162

Firms

Households

£bnRent, 5Wages 75 interest 20and profit Total 100

Expenditure on goods £100 bnand services

£100 bn

£125 bn

£125 bn

Question 3 (b): p.163• Economists test hypotheses and build economic models.

E.g., an economist might suggest that high investment leads to high per capita income. This could be tested by correlating statistics for 2 different economies.• Both economists and governments can make policy

recommendations based upon economic evidence. E.g. if transferring resources from richer to poorer nations, who should gain and who should lose?• Economists and governments are also interested in making

judgments about economic welfare. GNP per capita figures are an important measure of living standards.

• Figure 4 shows comparisons between countries which are relatively easy to understand.

Homework

• Read the section ‘Accuracy of national income statistics’ (pages 163-4)

• Answer question 4 on page 164• Read and make notes on the rest of pages 164

and 165• Answer question 5 on page 164