Nature of the Economy & Circular Flow of Income

Economics: Overview

• Studies how scarce resources are allocated to satisfy unlimited wants.
• Focus areas: production, consumption, trade, policy, growth.

Circular Flow of Income: Purpose

• Visual model linking the five sectors of an economy.
• Tracks money, resources, goods & services to judge if activity is expanding or contracting.

Sector Roles

Households

• Own economic resources (land, labour, capital, enterprise).
• Receive Y (wages, rent, interest, profit) for resources.
• Spend income on goods & services: C.

Firms

• Hire household resources ⇒ produce output.
• Receive C; pay Y to households.

Financial Sector

• Banks channel household/firm savings S (leakage) into investment I (injection).

Government Sector

• Collects taxation T (leakage).
• Spends on public goods & transfers G (injection).

Overseas Sector

• Imports M (leakage).
• Exports X (injection).

Injections vs Leakages & Equilibrium

• Leakages: S + T + M.
• Injections: I + G + X.
• Equilibrium when S+T+M = I+G+X.
  • I+G+X > S+T+M ⇒ economic growth.
  • S+T+M > I+G+X ⇒ economic decline.

Government Intervention

• Adjusts taxes, spending, regulation or credit conditions to balance flows and stabilise activity.