Circular Flow of Income

• The circular flow of income is a useful model for understanding the economy and can be used to derive conclusions about economic growth and GDP.
• In a simple economy, households provide factors of production to firms in the form of land, labor, capital, and enterprise.
• Each factor of production has a reward, which includes wages for labor, rent for land, profit for entrepreneurship, and interest for capital.
• Households spend their factor incomes on the goods and services made by firms.
• The circular flow of income model includes two fundamental sectors that are often ignored: the government and the international sector.
• Not all income earned in the economy is spent on goods and services produced in the economy, as some can be saved, taxed away, or spent on goods and services produced abroad.
• The circular flow of income model assumes that the only expenditure on goods and services produced in the economy is by households, which is another crazy assumption as there can be expenditure by firms, the government, and foreigners.
• Injections into the circular flow are ways in which money can enter the economy outside of consumer expenditure, including investment, government spending, and exports.
• Leakages from the circular flow are ways in which money can go out of the economy and not be spent on goods and services produced in the economy, such as savings, taxation, and imports.
• All three methods of calculating GDP, output, income, and expenditure, are equal to each other, indicating that they measure the same circular flow of income.
• If injections and leakages are equal to each other, it indicates macroeconomic equilibrium and neither economic growth nor decline is occurring.
• The expenditure method adds up the total expenditure on a country's goods and services in a year, including Consumer Expenditure, investment, government spending, and net exports.
• A transaction in an economy, such as buying a cricket bat, is an example of how spending equals output equals income, demonstrating that the three are always equal to each other.
• GDP, or Gross Domestic Product, is a measure of economic growth and can be calculated using the output method, which adds up the final value of all goods and services produced in an economy in a year.
• The income method adds up all the factor incomes earned in an economy in a year, including wages, salaries, profit, interest, and rent.
• Injections are greater than leakages, indicating more money is entering the economy than is leaving it, leading to economic growth.
• If injections are less than leakages, it means more money is going to be exiting the economy than is entering it, leading to economic decline.
• The full sector circular flow provides a more realistic view of our economy.