, The Circular Flow of Income: a model of
the economy that shows the movement of goods,
services and factors of production between
households and firms:
● Household consume goods and services
and receive wages from firms
● FOPs receive factor incomes in the form of
wages, salaries, rents, interest and profits
● Firms pay wages to workers and produce
output.
● The leakages from the circular flow (where money flows of the system) are taxes from
government, household savings and spending on imports
● The injections into the circular flow (where money flows into the system) are government
expenditure, exports and investment by firms into capital stock.
● The economy will be in overall balance when the injections are equal to leakages
Measuring national income, output and expenditure: The circular flow of income also
shows the three different ways that we can measure total economic activity in the economy - by
measuring total incomes, total output produced and total expenditure.
GDP (gross domestic product): the total level of economic activity carried out in an economy during a
given period.
Output = Income = Expenditure
National Output: The total final value of output produced by firms in a year deducting the cost of
intermediate goods (goods that are consumed in the process of production such as materials and
services)
National Income: (profit, dividends, income,interest, wages, rent) this is the total income received by
all FOPs in the economy in a year.
National Expenditure: The total amount spent on goods and services by different groups that
participate in the economy. The income approach can be calculated using the following formula:
GDP = C (consumption) + G (government spending) + I (investment) + NX (net exports) - also used
for measuring AD in the economy.
Aggregate Demand: the total demand for goods and services in an economy
AD = C (consumption) + G (government spending) + I (investment) + NX (net exports)
Why is AD downwards sloping?
● Wealth effect: as P increases, purchasing power decreases, reduces marginal propensity to
consume - Fall in C (an effect by which an increase in the average price level reduces
purchasing power and therefore the quantity of real output demanded)
● Trade effect: As price level increases, the competitiveness of domestic exports decreases
reducing demand for X and increasing demand for M
● Interest Rate Effect: as price level increases, interest rates will rise which increases the cost
of borrowing and decreases I + increases savings which decreases C
the economy that shows the movement of goods,
services and factors of production between
households and firms:
● Household consume goods and services
and receive wages from firms
● FOPs receive factor incomes in the form of
wages, salaries, rents, interest and profits
● Firms pay wages to workers and produce
output.
● The leakages from the circular flow (where money flows of the system) are taxes from
government, household savings and spending on imports
● The injections into the circular flow (where money flows into the system) are government
expenditure, exports and investment by firms into capital stock.
● The economy will be in overall balance when the injections are equal to leakages
Measuring national income, output and expenditure: The circular flow of income also
shows the three different ways that we can measure total economic activity in the economy - by
measuring total incomes, total output produced and total expenditure.
GDP (gross domestic product): the total level of economic activity carried out in an economy during a
given period.
Output = Income = Expenditure
National Output: The total final value of output produced by firms in a year deducting the cost of
intermediate goods (goods that are consumed in the process of production such as materials and
services)
National Income: (profit, dividends, income,interest, wages, rent) this is the total income received by
all FOPs in the economy in a year.
National Expenditure: The total amount spent on goods and services by different groups that
participate in the economy. The income approach can be calculated using the following formula:
GDP = C (consumption) + G (government spending) + I (investment) + NX (net exports) - also used
for measuring AD in the economy.
Aggregate Demand: the total demand for goods and services in an economy
AD = C (consumption) + G (government spending) + I (investment) + NX (net exports)
Why is AD downwards sloping?
● Wealth effect: as P increases, purchasing power decreases, reduces marginal propensity to
consume - Fall in C (an effect by which an increase in the average price level reduces
purchasing power and therefore the quantity of real output demanded)
● Trade effect: As price level increases, the competitiveness of domestic exports decreases
reducing demand for X and increasing demand for M
● Interest Rate Effect: as price level increases, interest rates will rise which increases the cost
of borrowing and decreases I + increases savings which decreases C
