National Income and the circular flow model-SECTION 1

• Circular Flow of Income and Spending


  Model that shows connections between different sectors of an economy
• Circular Flow of Income and Spending model

  • Shows flows of goods and services and factors of production between firms and households
  • Shows how national income or Gross Domestic Product is calculated
• Circular Flow of Income and Spending

  1. Businesses produce goods and services

  2. Incomes are generated for factors of production (land, labour, capital and enterprise)

  3. For example, wages and salaries going to people in work
• Sectors in the Domestic Circular Flow of Income & Spending

  • Households
  • Firms
  • Government
• Injections into the circular flow

  • Investment expenditure (I)
  • Government expenditure (G)
  • Export expenditure (X)
• Withdrawals from the circular flow

  • Saving (S)
  • Taxes (T)
  • Import expenditure (M)
• Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output
• Types of capital expenditure


  • Firms' investment expenditure on new technology (I)
  • Government expenditure on the NHS or defence (G)
  • Overseas consumers buying UK goods and services (X)
• Withdrawals or leakages from the circular flow are those parts of income that are not directly spent on domestically produced goods and services
• Types of withdrawals


  • Saving by households and firms (S)
  • Taxes paid to government by households and firms (T)
  • Import expenditure by UK households on foreign produced goods and services (M)
• An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow: Where I+G+X = S+T+M
• Investment expenditure


  Spending on capital goods not used up in the production process (e.g. buildings, machinery, technology, infrastructure) and the value of the physical increase in stocks and works-in-progress
• Components of Expenditure


  • Consumption (C) (consumer expenditure) spending by households on consumer durables, non-durables and services
  • Investment (I)
  • Government expenditure (G) (spending by central and local government on the provision of goods and services)
  • Net exports (X-M) (difference between export earnings and import payments)
• How changes in injections and withdrawals affect the circular flow and equilibrium

  1. An economy will be in equilibrium when planned withdrawals equal planned injections

  2. Savings, taxation and import spending (S+T+M) will equal investment, government spending and export revenue (+G+X)

  3. When total injections equal total withdrawals, the level of national income will remain constant, and the economy will be in general equilibrium
• General equilibrium


  For an economy to be in general equilibrium it is only necessary that total injections = total withdrawals
• 4. The level of economic activity will change following a change in either injections or withdrawals 5. An economy will grow if the value of injections is greater than the value of withdrawals, or shrink if the value of withdrawals is greater than injections
• National income

  The monetary value of the flow of output of goods and services produced in an economy over a period of time
• Measuring national income


  • Important for seeing the rate of economic growth
  • Changes to average living standards
  • Changes to the distribution of income
• Gross Domestic Product (GDP)


  The total value of output in an economy, used to measure change in economic activity
• GDP includes the output of foreign owned businesses that are located in a country following foreign direct investment
• Three ways of calculating GDP

  • Expenditure Method (Aggregate Demand)
  • Output Method
  • Income Method
• Expenditure Method (Aggregate Demand)


  GDP = C + I + G + (X - M)
• C


  Household spending
• I

  Capital Investment spending
• G


  Government spending
• X


  Exports of Goods and Services
• M


  Imports of Goods and Services
• To calculate GDP at factor cost, it is necessary to subtract expenditure taxes and add subsidies given to firms
• GDP at factor cost reflects the spending on the actual output produced by using factors of production
• The Income Method - adding factor incomes


  1. GDP is the sum of the incomes earned through the production of goods and services

  2. Income from people in jobs and in self-employment

  3. Profits of private sector businesses

  4. Rent income from the ownership of land
• Only those incomes that are come from the production of goods and services are included in the calculation of GDP by the income approach
• Incomes excluded from GDP by the income approach

  • Transfer payments (e.g. state pension, income support, Jobseekers' Allowance, housing benefit)
  • Private transfers of money from one individual to another
  • Income not registered with HMRC (shadow economy or black economy)
• Published figures for GDP by factor incomes will be inaccurate because much activity is not officially recorded - including subsistence farming, barter transactions and the shadow economy
• Value Added and Contributions to a Nation's GDP (Output method)


  1. Value added is the increase in the value of goods or services as a result of the production process

  2. Value added = value of production - value of intermediate goods
• Main wealth-generating sectors of the economy


  • Manufacturing
  • Oil & gas
  • Farming, forestry & fishing
  • Service-sector industries
• GNP = GDP + Net primary
• Net Primary Income


  The net balance of interest, profits and dividends (IPD) coming into a country from assets owned overseas minus profits and other income from foreign owned assets located within a country
• GNP is boosted by inflows of remittance incomes from people living and working abroad, which are three times the size of official development assistance and an important lifeline for millions of poor households in many of the least developed nations
• In the UK the figures for GDP and GNP are very similar, but in many other countries the two may diverge due to either a large proportion of Foreign Direct Investment (FDI), such as exists in the Republic of Ireland, where GNP is much lower than GDP, or a high level of remittances from people living and working abroad (here GNP would be much larger than GDP)
• Net National Product (NNP)

  Final measure of national income calculated by subtracting capital consumption or depreciation of capital stock from the GNI figures