Circular Flow of Income

1
The Circular Flow of Income
2
Intro Economic Models

• In order to explain or predict what might happen
  in the economy economists create economic models.
• Models are simplified ways of explaining how
  something works
• These vary from the very simple to very complex
• You have already come across the PPF as a model
  of the economy
• Now you will look at the circular flow model
  which looks at how money flows around the
  economy.
• We will build it up bit by bit, starting with a
  very simple version of the economy and gradually
  making it more complicated

3
The Circular Flow of Income
Consumer Spending

• There are only 2 groups in the economy
• Households
• Firms
• Firms supply households with goods and services,
  for which they receive payment
• Households provide firms with labour, for which
  they receive wages.
• This money is then spent on goods and services
  provided by firms and the cycle continues

Wages
4
The Circular Flow of Income
Of course households dont actually have to
spend all their income. Now we introduce
saving Households save in banks Banks lend to
firms who use this money to invest Households
reward for this is interest (of course
households can borrow to but this goes straight
back to households so we ignore it.)
C
Investment
Firms
Households
Lending
Saving
Wages
Wages Interest
5
The Circular Flow of Income
The other component of most household expenditure
is tax Government taxes both households and
firms. Some of this money is returned to
households through benefits The rest of the
government income is spent on goods and services
(govt spending)
I

Govt
C
Spending
Investment
Tax Benefits
Tax
Firms
Households
Lending
Saving
Wages Interest
6
The Circular Flow of Income

-
X
G
M

Exports
I
So far we have assumed there is no trade in the
economy (sometimes called autarky) NB we are
following money NOT goods Imports take money
out of the economy Exports bring money into the
economy.

C
Govt
Imports
Spending
Investment
Tax Benefits
Tax
Firms
Households
Lending
Saving
Wages Interest
7
The Circular Flow of Income

-
X
M
G

The only thing missing now is the remainder of
household income. Remember households supply all
the factors of production This means that they
must receive payment for each one We already
have Labour Wages Capital Interest
(money lent to invest
in capital) We need to add Land Rent
Enterprise - Profit
I

Govt
C
Spending
Investment
Tax Benefits
Tax
Firms
Households
Lending
Saving
Rent Wages Interest Profit
Wages Interest
8
The Circular Flow of Income

-
X
M
G

The only thing missing now is the remainder of
household income. Remember households supply all
the factors of production This means that they
must receive payment for each one We already
have Labour Wages Capital Interest
(money lent to invest
in capital) We need to add Land Rent
Enterprise - Profit
I

Govt
C Consumer spending I Investment G
Government Spending X Exports M - Imports
C
Spending
This is total demand in the economy, also called
Aggregate Demand. Remember this we will come
across it later.
Investment
Tax Benefits
Tax
Firms
Households
Lending
Saving
Rent Wages Interest Profit
9
The Circular Flow of Income

-
X
M
G

The only thing missing now is the remainder of
household income. Remember households supply all
the factors of production This means that they
must receive payment for each one We already
have Labour Wages Capital Interest
(money lent to invest
in capital) We need to add Land Rent
Enterprise - Profit
I

Govt
C
Spending
Investment
Tax Benefits
Tax
Firms
Households
Lending
Saving
Rent Wages Interest Profit
10
National Income

-
X
M
G

I

National Income The flow of new output or
wealth produced using the resources available to
a country
C
Firms
Households
Rent Wages Interest Profit
11
National Income

-
X
M
G

I

National Income The flow of new output or
wealth produced using the resources available to
a country
C
Firms
Households
Rent Wages Interest Profit
12
National Income

-
X
M
G

There are 3 ways of measuring national
income Product Method (Q) The total value of
all the goods and services produced within an
economy Income Method (Y) The total income
received by all factors of production Expenditure
Method (E) Total expenditure on all the output
from the economy
I

C
Firms
Households
Rent Wages Interest Profit
13
National Income

-
X
M
G

There are 3 ways of measuring national
income Product Method (Q) The total value of
all the goods and services produced within an
economy Income Method (Y) The total income
received by all factors of production Expenditure
Method (E) Total expenditure on all the output
from the economy
I

C
Firms
Households
Rent Wages Interest Profit
14
National Income

-
X
M
G

As you can see from the diagram, while they are
all measuring different things they must have the
same value. This means that we can use them
interchangeably QTE
I

C
Firms
Households
Rent Wages Interest Profit
15
National Income
National Income and AD You will have noticed
that National Expenditure and Aggregate Demand
are very similar. They are, in face, identical in
all but 1 important difference. Aggregate Demand
measures what people plan to spend. (If the price
level is x I will spend this) National
Expenditure measures what people actually
spent One is the intention at any given price
level, the other is the action. Technically we
say that one is ex ante and the other is ex post
but these are not terms you need to know.

-
X
M
G

As you can see from the diagram, while they are
all measuring different things they must have the
same value. This means that we can use them
interchangeably QTE
I

C
Firms
Households
Rent Wages Interest Profit