4.2 Circular Flow of Income

What is the most simplified circular flow model

Shows how income, spending and output move around an economy
 - This flow explains why GDP can be measured by calculating the country's output, income and expenditure

What is the circular flow of income

A model showing how money, goods, and services move between households, firms, government, and the foreign sector in an economy.

Who are the main participants in the circular flow of income

Households, firms, government, and the foreign sector.

What role do households play in the circular flow

They provide factors of production (land, labour, capital, enterprise) to firms, receive income, and spend on goods and services.

What role do firms play in the circular flow

They produce goods and services, pay income to households, and earn revenue from sales.

What is a closed economy in the circular flow context

An economy that only includes households and firms, with no government or foreign trade.
 - An economy that does not trade with other economies (no imports or exports)

What does the circular flow look like in a closed economy

What is an open economy in the circular flow context

An economy that includes households, firms, government, and foreign trade (exports and imports).
 - An economy that is involved in trade with other economies

What does the circular flow look like in a open economy

What are injections in the circular flow + examples (3)

Money entering the economy other than from households’ spending, e.g., investment, government spending, exports. (GIX)
 - Additions to the circular flow of income

What are leakages in the circular flow + examples (3)

Money leaving the economy, e.g., savings, taxes, and imports. (STM)
 - Withdrawals from the circular flow of income

What is equilibrium in the circular flow of income

When total injections equal total leakages, and national income is stable.

What is disequilibrium in the circular flow of income

When injections do not equal leakages, causing national income to rise or fall.

What happens if injections exceed leakages

If injections are greater than leakages, there will be extra spending in the economy causing income to rise
 - National income rises, firms increase production, employment rises, and the economy expands.

What happens if leakages exceed injections

If leakages are greater than injections, more spending will leave the circular flow so income will fall.
 - National income falls, firms reduce production, unemployment rises, and the economy contracts.

What formula represents equilibrium in an open economy

I + G + X = S + T + M

Show equilibrium income in a closed economy without a government (diagram)

Such an economy has only two sectors: households and firms

What would be the effect of a rise in investment in a two sector economy (diagram + explanation)

A rise in investment would cause a rise in GDP as higher investment results in an increase in production, income and spending.
 - A fall in savings would have a similar effect, but in contrast, an increase in saving will mean that some products are being unsold so production will fall.

Show equilibrium income in a four-sector economy (diagram)

Where injections (GIX) = leakages (STM)
 - Income will move to a higher level if any injection rises or any withdrawal falls & vice versa

What are the four sectors in a four sector economy (circular flow)

• Households, firms, the government, and the international economy

Show on a diagram the impact of a rise in taxation on equilibrium income in a four-sector economy + explanation.

If tax rates rise with no change in government spending, tax revenue collected from households will increase, reducing their disposable income they have available for spending hence the fall in GDP.
 - A rise in saving or imports will also cause GDP to fall, at least in the short run

Key concept link - equilibrium

In the long run, what can happen to injections and leakages + example (starting with increase in investment)

In the long run, links can occur between changes in injections and leakages
 - For instance, an increase in investment will raise incomes. As people get richer, they tend to save more. Extra savings can finance more investment. Higher government spending may raise tax revenue by increasing incomes. A greater value of exports will also increase incomes. As incomes rise, more tends to be spent not only on domestically produced products but also on imports.

Key concept link - time

Why is the circular flow of income useful

It shows the interdependence of economic sectors and helps explain changes in national income and employment.