The Circular Flow of Income

• The circular flow of income is an economic model that illustrates money flows in an economy

  • There is a simple model which shows the money flows between households and firms

  • There is a more complex model which adds in other economic agents including the government, financial sector and foreign trade (net exports)
    

A diagram showing the simplified Circular Flow of Income between households and firms

Diagram Analysis

• Households own the wealth in the economy

  • These are the factors of production

• Households supply their factors of production to firms and receive income as a reward

  • They receive rent for land, wages for labour, interest for capital, and profit for enterprise

  • With this income, they purchase goods/services from firms

• Firms purchase factors of production from households

• They use these resources to produce goods/services

  • They sell the goods/services to households and receive sales revenue

• National income is the value of the output of an economy over a period of time

  • It can be calculated using the income approach or expenditure approach

  • Expenditure = income
    

• Income is a flow in the economy, whereas wealth is a stock of assets that can be used to generate income