The Circular Flow of Income

Question 1

Income flows between firms and households

Answer 1

1. An economy is made up of firms and households
2. Firms produe goods and services, and all of these goods and services make up the national output
3. Households in a country provide the labour, land and capital that firms use to produce the national output. The money paid to households by firms for these factors of production = national income
4. Households spend money they get from national income on goods and services that firms create - value of this spending = national expenditure
5. circular of flow income:
   National Output = National Income = National Expenditure
6. Flow of income can also be shown as a diagram (pg 136 in CGP)
   There are two flows here:
   - Physical flow of ‘real things’ - i.e. goods, services, labour, land and capital
   - Monetary flow - i.e. money that pays for the ‘physical things’

Question 2

There are injections into and withdrawals from the flow of income

Answer 2

1. circular flow suggests that as long as households keep spending what they earn, and firms keep using their revenues to produce to produce more goods using the same inputs, then national output wont change
2. However, an economy’s circular flow of income is affected by injections and withdrawals
3. Injections into the circular flow of income come in the form of exports, investments and government spending - these go directly into firms
4. Withdrawals come in the form of imports, savings and taxes - these withdrawals can be made by households or firms
5. Check the diagram on pg 136
   - If injections and withdrawals are equal, then the economy is in equilibrium
   - If injections into the circular flow are greater than withdrawals, this means that expenditure is greater than output - so firms will increase output. As a result national output, income and expenditure will all increase
   - If withdrawals from the circular flow are greater than injections this means that output is greater than expenditure - so firms will reduce output. As a result national output, income and expenditure will decrease.

Question 3

Injections have a multiplier effect on the circular flow

Answer 3

1. When injection made into circular flow, the actual change in national income is greater than the initial injection = multiplier effect. (look at example in rev bk)
2. size of multiplier effect depends on the rate at which money leaks from the circular flow - e.g. the bigger the leakages, the quicker themoney will leave the circular flow and the smaller the multiplier effect will be
3. If lots of money is being spent on imports then the multiplier effect will actually be quite small because the injection will quickly leak out of the circular flow

Question 4

Wealth is different to income

Answer 4

1. Wealth = total value of assets owned by firms or individuals in a country
2. Assets include actual money e.g. savings, + physical items e.g. houses and cars
3. Unlike income, which = flow of money, wealth is a stock concept - like stockpiling of resources. These resources aren’t currently being used in the circular flow of income - but they could be at some point
4. Although income and wealth are different things there’s a correlation between them, for example, likely that an individual with high income will also have high wealth - be able to purchase more expensive assets and have a more money to save.