2.4: Circular flow of Income

• What is the circular flow of income?

  It is an economic model that illustrates money flows in an economy.
• What does the simple model of the circular flow of income illustrate?

  It shows the money flows between households and firms.
• What additional agents are included in the more complex model of the circular flow of income?

  The government, financial sector, and foreign trade (net exports) are included.
• Who owns the wealth in the economy?

  Households own the wealth in the economy.
• What are the factors of production?

  They are the resources used to produce goods and services.
• How do households receive income in the circular flow of income model?

  They supply their factors of production to firms and receive income as a reward.
• What types of income do households receive for their factors of production?

  They receive rent for land, wages for labour, interest for capital, and profit for enterprise.
• What do households do with the income they receive?

  They purchase goods and services from firms.
• What do firms do with the factors of production they purchase from households?

  They use these resources to produce goods and services.
• What do firms receive when they sell goods and services to households?

  They receive sales revenue.
• What is national income?

  It is the value of the output of an economy over a period of time.
• How can national income be calculated?

  It can be calculated using the income approach or the expenditure approach.
• What does the income approach to calculating national income involve?

  It involves adding income from factors of production.
• What does the expenditure approach to calculating national income involve?


  It involves adding expenses from factors of production.
• What is the relationship between expenditure and income in the economy?

  Expenditure equals income.
• How is income different from wealth in the economy?

  Income is a flow in the economy, whereas wealth is a stock of assets that can be used to generate income.
• What do injections do to the circular flow of income?

  Injections add money into the circular flow of income and increase its size
• What are three examples of injections in the circular flow of income?

  Increased government spending (G), increased investment (I), and increased exports (X)
• What do withdrawals or leakages do to the circular flow of income?

  Withdrawals or leakages remove money from the circular flow of income and reduce its size
• What are three examples of withdrawals in the circular flow of income?

  Increased savings by households (S), increased taxation by the government (T), and increased import purchases (M)
• What is the relationship between injections and withdrawals in the economy to determine growth/decline?

  • Injections > withdrawals = economic growth
  • Withdrawals > injections = fall in real GDP
• What do injections represent in the economy?

  Injections represent new income in the economy
• What is the multiplier effect?

  The multiplier effect can cause the economy to grow by a greater amount than the size of the injection
• How does an increase in government spending affect households?

  It becomes income for households who then spend it purchasing goods/services
• What happens to the money spent by households after receiving income from government spending?

  Households spend it purchasing goods/services from firms
• What do firms do with the money they receive from households?

  Firms spend some of it on purchasing raw materials
• What factors influence the circular flow of income?

  • Government spending
  • Investment
  • Consumption
  • Net exports
• What effect does an increase in interest rates have on savings and consumption?

  An increase in interest rates will increase savings as the cost of borrowing increases, making goods and services more expensive. Thus reduce consumption