A-Level Economics Notes on the Circular Flow of Income

Definitions

1. Circular Flow of Income: A model that illustrates how money moves through the economy between producers, consumers, and financial institutions in the form of payments for goods and services, wages, rents, and taxes.
2. Households: Individuals or groups of people living together who provide labor and other factors of production to businesses and receive wages, rent, dividends, and interest in return.
3. Firms/Businesses: Organizations that produce goods or provide services and pay wages, rent, interest, and profits in return for factor services.
4. Government: The public sector entity that collects taxes and injects spending into the economy through public services and welfare.
5. Financial Sector: Institutions that facilitate the flow of funds between savers and borrowers, influencing the level of investment and savings in the economy.
6. Foreign Sector: The rest of the world with which the domestic economy interacts, trading goods, services, and financial assets.
7. Leakages: Money that exits the economic cycle and is not immediately available for spending on domestic output, including savings, taxes, and money spent on imports.
8. Injections: Money introduced into the economic cycle, which adds to the spending stream and can stimulate economic activity, including investment, government spending, and export revenues.
9. Savings: Income not spent on consumption goods and services but retained for future use, often placed in financial institutions.
10. Investment: Expenditure on capital goods that will be used to produce other goods and services in the future. This includes business spending on equipment and infrastructure.
11. Taxes: Compulsory payments made by individuals and organizations to the government, used to fund public services and welfare.
12. Imports: Goods and services bought by residents of a country from foreign producers, representing an outflow of funds from the country.
13. Exports: Goods and services sold by domestic producers to foreign consumers, representing an inflow of funds to the country.
14. Subsidies: Payments made by the government to reduce the producers’ costs or lower the price of goods and services to consumers.
15. Transfer Payments: Payments made by the government to individuals, such as welfare benefits, which are not made in exchange for goods or services produced.
16. Gross Domestic Product (GDP): The total value of all goods and services produced within a country over a specific period.
17. National Income: The total income earned by a country’s factors of production within a given time period, including wages, rent, interest, and profits.
18. Disposable Income: The income households have available to spend or save after taxes have been deducted and social security benefits have been added.
19. Marginal Propensity to Consume (MPC): The proportion of additional income that a household is likely to spend on consumption.
20. Marginal Propensity to Save (MPS): The proportion of additional income that a household will save rather than spend on consumption.
21. Multiplier Effect: The process by which an increase in spending (an injection) leads to an increased income and therefore further increased spending and income.

Diagrams

Components of the Circular Flow

1. Households: Individuals or groups of people living together who provide factors of production to businesses and receive wages, rent, dividends, and interest in return.
2. Firms/Businesses: Entities that produce goods and services. They hire factors of production from households and pay them income, which they earn from selling goods and services.
3. Government: The public sector that imposes taxes on households and firms, provides public goods and services, and redistributes income.
4. Financial Sector: Consists of banks and other financial institutions that facilitate the flow of money by providing loans and savings opportunities.
5. Foreign Sector: Represents trade and economic interaction with other countries, including exports, imports, and financial flows.

Assumptions of the Model

• Closed Economy: No foreign sector is involved, and all activity is within the domestic economy.
• Two Sector Model: Only includes households and businesses, simplifying the flow to just these entities.
• No Savings or Investment: All income received by households is spent on consumption.
• No Government: Taxes, government spending, and subsidies are absent in the simplest model.

The Two-Sector Model

• Income Flow: Households provide labor to firms, and in return, they receive wages. They spend their income on goods and services produced by the firms.
• Product Flow: Firms provide goods and services to households in exchange for consumer expenditure.

The Three-Sector Model (Inclusion of Government)

• Taxes: Households and firms pay taxes to the government, which in turn, spends on public services and welfare.
• Government Spending: Government purchases goods and services from firms and provides subsidies and welfare benefits to households.

The Four-Sector Model (Open Economy)

• Exports and Imports: Firms export goods to the foreign sector and import goods and services for domestic consumption.
• Financial Flows: Investments, loans, and aid that flow into and out of the country.

Leakages and Injections

• Leakages: Savings, taxes, and imports are leakages in the circular flow as they represent income not spent on domestic output.
• Injections: Investment, government spending, and exports are injections as they introduce additional spending into the economy.

Leakages

Leakages are non-consumption uses of income by households or firms, which means that the money is taken out of the economic flow and is not used for immediate expenditure on goods and services. The three main types of leakages are:

1. Savings: When households save part of their income, they withdraw potential spending from the economy. Savings are held in bank accounts or other financial instruments and are not used for consumption or immediate reinvestment into the economy.
2. Taxes: Taxes collected by the government from households and firms reduce the amount of disposable income available for spending. While taxes are necessary for providing public services and infrastructure, they represent a withdrawal of spending power from the economy.
3. Imports: When firms and households buy goods and services from other countries, money flows out of the domestic economy to pay for these imports. This represents a leakage because it is spending that does not go towards purchasing domestically produced goods and services.

Injections

Injections are additions to the economy’s spending stream that occur when money is introduced into the circular flow, increasing the potential for economic activity. The three main types of injections are:

1. Investment: This is spending by firms on capital goods such as machinery, equipment, and buildings. Investment is crucial for increasing productive capacity and supporting economic growth. It can come from retained earnings within firms, borrowings, or new equity from the financial sector.
2. Government Spending: Government expenditure on goods and services, infrastructure, education, and welfare support injects money into the economy. This spending can stimulate further economic activity by providing income to households and firms, which can then be spent.
3. Exports: When firms sell goods and services to customers outside the domestic economy, they bring money into the economy. Exports are an essential source of income for many businesses and contribute to national income.

Real Flows vs. Money Flows

• Real Flows: The physical exchange of goods and services between firms and households, and the provision of factor services from households to firms.
• Money Flows: The monetary exchange for goods, services, and factor services, including wages, rents, interest, and profits.