Economics: The Circular Flow of Income
Key Terms
Circular Flow of Income: The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods, services, etc. between economic agents.
Leakages: The loss of revenue through, savings, taxation, and imports.
Injections: Refers to the circular flow of income model where money gets ‘injected’ (added) from either; government spending, investments, or exports.
What is Macroeconomics?
Macroeconomics is the study of the economy as a whole. It looks at the overall level of economic activity, including inflation, unemployment, and economic growth. It takes into account the country's production output as well the global economy.
The Circular Flow of Income, Expenditure, and Output
Since this is now macroeconomics, we need to look at a basic model of how the economy works. The key players in an economy as we know are firms, households and government and we need to know how these agents interact at a macroeconomic level.
The circular flow of income, expenditure and output helps provide us with a basic framework of a country's economy.
Within the circular flow of income, diagram we can see two key economic agents, firms, and households. These economic agents essentially power the economy with households providing their labour to firms in exchange for wages, and the wages are then spent on goods/services provided by firms.
This causes a loop effect, however as we know money also enters the economy and money leaves the economy, these are known as injections and leakages.
Injections are money that enters the economy this can be done in three main ways:
Government Expenditure (G) – This is where the government spends money within the economy by buying goods/services such as the provisions of public goods or investing in infrastructure.
Exports (X) – This is money we get from selling our goods and services abroad.
Investment (I) – This is money received from investments by firms such as multinationals building factories and purchasing capital in the country.
Leakages are money that leaves the economy, this can be done in three main ways:
Taxes (T) – Taxes that households and firms have to pay to the government such as VAT and income tax.
Imports (M) – Purchasing goods and services from the rest of the world causes the money to exit the economy.
Savings (S) – Household saving also keeps money out of the economy as it is not moving.
This entire model is illustrated below:
The Economy and Balance
As can be seen in the diagram above, according to it the economy is in a consistent open loop with money moving around and entering and exiting via the various leakages and injections. This model aims to explain that the economy needs to stay in a balance with the money entering the economy equating to that leaving the economy.
However, as we know the economy is not always in balance with more money leaving the economy then entering in majority of cases!
What is Gross Domestic Product (GDP)
The gross domestic product (GDP) is the total economic activity in an economy at a given time period. GDP is measured by looking at the national income, output, and expenditure. The GDP provides us with key a key perspective on a countries economic health and allows us to analyse growth.
Measuring National Income, Output & Expenditure
In order to measure national income, output, and expenditure we can use the circular flow of income diagram as can be seen below. By selecting a chunk of factors income, we can find out the national income, by looking at a specific chunk of the output of goods and services we can find out the national output and the same goes for expenditure.
It is key to remember that GDP is not accurate but rather an estimate of what is going on in the economy. It is also important to be able to understand what ‘real’ GDP is – this is GDP adjusted for changing prices.
References/Further Reading
Circular Flow of Income – Wikipedia - https://en.wikipedia.org/wiki/Circular_flow_of_income
Gross Domestic Product – Wikipedia - https://en.wikipedia.org/wiki/Gross_domestic_product