Circular flow of income
->useful way of modelling the economy
o There are two simple economic agents: households and firms
o Households provide their four factors of production to firms in the form of land,
labour, capital and enterprise
o Firms combine them to make goods and services
o In reward for providing the factors of production households receive factor incomes
from firms
Factor Reward
Land Rent
Labour Wages
Capital Interest
Enterprise Profit
Using all their factor incomes household
expenditure is paid to firms for all the output
o Based on the assumptions
There is no saving
There is no surplus output
There is no foreign trade
output=income=expenditure
Real world situation
Leakages Injections
Saving-> households save part of their factor Investment-> household savings are ‘recycled’
incomes that they don’t spend on goods and by banks to provide loans to firms or bought in
services exchange for shares to provide investment
capital for firms
Tax-> firms and households have to pay tax to Government spending-> the government
the government ‘recycles’ tax in the form of government
spending to pay for public services used by
households (e.g. education and healthcare)
Imports-> consist of raw materials/ Exports-> consist of raw materials/
components and capital goods (for firms) and components and capital goods (for firms
finished consumer goods for households + abroad) and finished consumer goods for
services for both households and firms households + services for both households and
firms abroad
, If injections are equal to leakages, then the economy is in equilibrium
If injections are greater than leakages, then expenditure is greater than
output and so firms will increase national output, income, and expenditure
If withdrawals are greater than injections output is greater than
expenditure so firms will reduce output so national output, income and
expenditure will decrease
Difference between wealth and income
WEALTH is the total value of all the assets owned by individuals or firms in an
economy
A STOCK CONCEPT
Measured at a specific point in time
o they can include actual money, e.g., savings and physical items like cars or
houses
INCOME is a flow of money
A FLOW CONCEPT
Measured over a period of time
o The value (in monetary terms) received by a person, household, firm or
country generally in exchange for goods or services
Even though they are different concepts there's a correlation between them. For
example, it's likely that an individual with a high income will also have high wealth
because they will be able to purchase more expensive assets and will also have more
money to save
National income
The equivalent to the monetary value of the economy in a given time period
National income is measured as GDP
There are three methods of measuring it
o Income method: GDP (I): payments by firms to households for factors of
production
Calculated as total compensation to employees + gross profits for
incorporated and non-incorporated firms plus property income
Excluded: Transfer payments by government (e.g. pensions and
benefits), transfers between private individuals, any income earned in
the shadow economy and not declared.
o Output method GDP (O): the value of all outputs by firms calculated by the
value added by firms in the chain of production
Calculated as the total of all value added by firms. Value added is the
difference between what firms have paid for materials and
components.
o Expenditure method (E): C+I+G+(X-M) spending by households on firms
outputs plus injections of investment, government spending (excluding
welfare) and exports minus imports
Calculated as C+I+G+(X-M); government expenditure excludes transfer
payments
Real National Income
Adjusted for inflation therefore it excludes inflation
,Aggregate demand
Aggregate demand is a measure of the total amount of demand for all finished goods
and services produced in an economy
It is expressed as the total amount of money spent on those goods and services at a
specific price level and point in time
It consists of all Consumption + Investment+ Government spending + (exports –
imports)
AD = C+I+G+(X-M)
Since output= income= expenditure its common for AD to be known as national
income or total output
The monetary value of AD is known as Gross Domestic Product (GDP)
Therefore AD is the same as National Income and GDP
The circular flow of income and the
components of AD
Injections cause an increase in AD
Leakages cause a decrease in AD
If they are equal to each other
Macro-economic equilibrium has
been reached
CONSUMPTION (and saving)
Consumption is spending by households (and/ or consumers) on goods and services
(produced in the domestic economy) it excludes exports
Consumption is the most significant part of aggregate demand, accounting for
around 65-70%
o Does not include spending by firms
Increase in consumption=increase in AD
Savings are made instead of consumption so when consumption is high, savings are
low
Influences on consumption
1. Real disposable income
2. Consumer confidence and expectations
3. Interest rates
4. Availability of credit
5. Wealth effect
6. Inflation
7. Distribution of income
, Real disposable income
Economic definition: real income after direct taxes (income tax and National
Insurance)
o “real” excludes inflation
Wider definition: real income that remains after direct taxes and spending on
necessities such as housing, food, energy, pension payments…
As disposable income rises, consumption rises
The rate at which consumption rises is less than the rate at which income rises
because households tend to save more when they earn more
Further explanation
Those who have less income tend to spend proportionately more of their remaining
income because they have less disposable income remaining after spending on
necessities
Average propensity to consume (APC)
o The proportion of disposable income that is spent not saved, i.e. household
expenditure ¸disposable income
Consumer confidence
When consumers feel more confident about the economy and their own financial
situation, they spend more and save less
Factors that effect confidence include: inflation, job security and job prospects +
salary levels
Interest rates
High interest rates lead to less consumer spending
Consumers save more to take advantage of the higher rates and they are less likely
to borrow money or buy things on credit because its more expensive
Consumers may also have less money to spend if interest rates on existing loans and
mortgages increase
Availability of credit
Whilst interest rates are main determinant of borrowing and saving, borrowing can
also be affected by the availability of credit from banks
This is determined by: Willingness of banks to lend based on risk Level of restrictions
on lending
This is related to the interest rates as when interest rates are high the demand to
borrow money will decrease as the cost of borrowing is high however when interest
rates are low the demand to borrow money will increase
Wealth effect
Wealth is what people own (assets)
->useful way of modelling the economy
o There are two simple economic agents: households and firms
o Households provide their four factors of production to firms in the form of land,
labour, capital and enterprise
o Firms combine them to make goods and services
o In reward for providing the factors of production households receive factor incomes
from firms
Factor Reward
Land Rent
Labour Wages
Capital Interest
Enterprise Profit
Using all their factor incomes household
expenditure is paid to firms for all the output
o Based on the assumptions
There is no saving
There is no surplus output
There is no foreign trade
output=income=expenditure
Real world situation
Leakages Injections
Saving-> households save part of their factor Investment-> household savings are ‘recycled’
incomes that they don’t spend on goods and by banks to provide loans to firms or bought in
services exchange for shares to provide investment
capital for firms
Tax-> firms and households have to pay tax to Government spending-> the government
the government ‘recycles’ tax in the form of government
spending to pay for public services used by
households (e.g. education and healthcare)
Imports-> consist of raw materials/ Exports-> consist of raw materials/
components and capital goods (for firms) and components and capital goods (for firms
finished consumer goods for households + abroad) and finished consumer goods for
services for both households and firms households + services for both households and
firms abroad
, If injections are equal to leakages, then the economy is in equilibrium
If injections are greater than leakages, then expenditure is greater than
output and so firms will increase national output, income, and expenditure
If withdrawals are greater than injections output is greater than
expenditure so firms will reduce output so national output, income and
expenditure will decrease
Difference between wealth and income
WEALTH is the total value of all the assets owned by individuals or firms in an
economy
A STOCK CONCEPT
Measured at a specific point in time
o they can include actual money, e.g., savings and physical items like cars or
houses
INCOME is a flow of money
A FLOW CONCEPT
Measured over a period of time
o The value (in monetary terms) received by a person, household, firm or
country generally in exchange for goods or services
Even though they are different concepts there's a correlation between them. For
example, it's likely that an individual with a high income will also have high wealth
because they will be able to purchase more expensive assets and will also have more
money to save
National income
The equivalent to the monetary value of the economy in a given time period
National income is measured as GDP
There are three methods of measuring it
o Income method: GDP (I): payments by firms to households for factors of
production
Calculated as total compensation to employees + gross profits for
incorporated and non-incorporated firms plus property income
Excluded: Transfer payments by government (e.g. pensions and
benefits), transfers between private individuals, any income earned in
the shadow economy and not declared.
o Output method GDP (O): the value of all outputs by firms calculated by the
value added by firms in the chain of production
Calculated as the total of all value added by firms. Value added is the
difference between what firms have paid for materials and
components.
o Expenditure method (E): C+I+G+(X-M) spending by households on firms
outputs plus injections of investment, government spending (excluding
welfare) and exports minus imports
Calculated as C+I+G+(X-M); government expenditure excludes transfer
payments
Real National Income
Adjusted for inflation therefore it excludes inflation
,Aggregate demand
Aggregate demand is a measure of the total amount of demand for all finished goods
and services produced in an economy
It is expressed as the total amount of money spent on those goods and services at a
specific price level and point in time
It consists of all Consumption + Investment+ Government spending + (exports –
imports)
AD = C+I+G+(X-M)
Since output= income= expenditure its common for AD to be known as national
income or total output
The monetary value of AD is known as Gross Domestic Product (GDP)
Therefore AD is the same as National Income and GDP
The circular flow of income and the
components of AD
Injections cause an increase in AD
Leakages cause a decrease in AD
If they are equal to each other
Macro-economic equilibrium has
been reached
CONSUMPTION (and saving)
Consumption is spending by households (and/ or consumers) on goods and services
(produced in the domestic economy) it excludes exports
Consumption is the most significant part of aggregate demand, accounting for
around 65-70%
o Does not include spending by firms
Increase in consumption=increase in AD
Savings are made instead of consumption so when consumption is high, savings are
low
Influences on consumption
1. Real disposable income
2. Consumer confidence and expectations
3. Interest rates
4. Availability of credit
5. Wealth effect
6. Inflation
7. Distribution of income
, Real disposable income
Economic definition: real income after direct taxes (income tax and National
Insurance)
o “real” excludes inflation
Wider definition: real income that remains after direct taxes and spending on
necessities such as housing, food, energy, pension payments…
As disposable income rises, consumption rises
The rate at which consumption rises is less than the rate at which income rises
because households tend to save more when they earn more
Further explanation
Those who have less income tend to spend proportionately more of their remaining
income because they have less disposable income remaining after spending on
necessities
Average propensity to consume (APC)
o The proportion of disposable income that is spent not saved, i.e. household
expenditure ¸disposable income
Consumer confidence
When consumers feel more confident about the economy and their own financial
situation, they spend more and save less
Factors that effect confidence include: inflation, job security and job prospects +
salary levels
Interest rates
High interest rates lead to less consumer spending
Consumers save more to take advantage of the higher rates and they are less likely
to borrow money or buy things on credit because its more expensive
Consumers may also have less money to spend if interest rates on existing loans and
mortgages increase
Availability of credit
Whilst interest rates are main determinant of borrowing and saving, borrowing can
also be affected by the availability of credit from banks
This is determined by: Willingness of banks to lend based on risk Level of restrictions
on lending
This is related to the interest rates as when interest rates are high the demand to
borrow money will decrease as the cost of borrowing is high however when interest
rates are low the demand to borrow money will increase
Wealth effect
Wealth is what people own (assets)
