CHAPTER 41: The circular flow of Income
The circular flow of income
The circular flow model is a simplified representation of how the basic decision-making units of
an economy (households, firms, the government and foreign sector) interact in an ‘open’
economy. It describes the flows between these units. These flows can be real (flows of factors
of production, flows of goods and services) or monetary (flows of expenditures on goods and
services, flows of incomes) generated in the production process.
Income in an economy flows from one part to another whenever a transaction takes place. New
spending generates new income, which generates further new spending, and further new
income, and so on. Spending and income continue to circulate around the macro economy in
what is referred to as the circular flow of income.
Leakage or Withdrawal refers to those parts of national income that are not used for
consumption. A withdrawal from the circular flow is therefore spending which does not flow
back from household to firms. Injections are supplementary expenditure not originating from
the domestic households.
There are indirect links between saving and investment, taxation and government expenditure,
and imports and exports, via financial institutions, the government (central and local) and
foreign countries respectively. If more money is saved, there will be more available for banks
and other financial institutions to lend out. If tax receipts are higher, the government may be
keener to increase its expenditure. Finally, if imports increase, incomes of people abroad will
increase, which will enable them to purchase more of our exports.
Equilibrium in the circular flow:
In equilibrium, injections are equal to withdrawals. If for example, injections exceed
withdrawals; this will lead to a rise in national income. But as national income rises, so
households will not only spend more on domestic goods (Cd), but also save more (S), pay more
taxes (T) and buy more imports (M). In other words, withdrawals will rise. This will continue
until they have risen to equal injections. At that point, national income will stop rising, and so
will withdrawals. Equilibrium has been reached.
, NATIONAL INCOME DETERMINATION
The level of national income in an economy is determined where aggregate demand equals
aggregate supply. This is also where aggregate expenditure is equal to output. Aggregate
expenditure is the total amount that will be spent at different levels of GDP in a given time
period. It is made up of Consumption C, Investment I, government spending G, and net exports;
that is exports minus imports X-M.
If aggregate expenditure exceeds current output, firms will seek to produce more. They will
employ more factors of production and GDP will rise. Whereas if aggregate expenditure is
below current output, firms will reduce production, so output will change until it matches
expenditure as shown in below figure.
If aggregate expenditure rises, perhaps because consumption and investment increase due to
greater optimism, output will increase. Figure 41.4 shows GDP increasing from Y to Y1.
The level of production in the economy depends on the level of aggregate demand. If people
buy more, firms will produce more in response to this, given that they have spare capacity. If
people buy less, firms will cut down their production and lay off workers. But just how much will
national income rise or fall as aggregate demand changes? We will answer this as we progress.
Looking at the diagram, the consumption of domestically produced goods (Cd) and the three
withdrawals (W) – net saving (S), net taxes (T) and spending on imports (M) all depend on the
level of national income (Y). In fact, in the model, national income must always equal
consumption of domestic goods plus withdrawals: there is nothing else people can do with their
incomes!
Y ≡ Cd +W
Total spending in the economy on the goods and services of domestic firms is defined as
aggregate demand (AD) or Aggregate Expenditure. Aggregate expenditure consists of Cd plus
the three injections (J): investment in the domestic economy (I), government expenditure in the
domestic economy (G) and expenditure from abroad on the country’s exports (X).
AD ≡ AE ≡ Cd + J
In equilibrium, withdrawals equal injections. Since national income (Y) is simply withdrawals
plus Cd, and aggregate expenditure (E) is simply injections plus Cd, it follows that in equilibrium
national income must equal aggregate expenditure.
To summarize:
W= J
Therefore, Cd + W = Cd + J
Y = E (= AD)
Components of Aggregate demand and their determinants
There is a range of influences on how much households spend. The main influence is usually
income and this is why economists study in depth. The rate of interest can affect how much
households spend. Expectations can play a role almost as important as income. The distribution
of income also influences consumption.
Consumption Function
The circular flow of income
The circular flow model is a simplified representation of how the basic decision-making units of
an economy (households, firms, the government and foreign sector) interact in an ‘open’
economy. It describes the flows between these units. These flows can be real (flows of factors
of production, flows of goods and services) or monetary (flows of expenditures on goods and
services, flows of incomes) generated in the production process.
Income in an economy flows from one part to another whenever a transaction takes place. New
spending generates new income, which generates further new spending, and further new
income, and so on. Spending and income continue to circulate around the macro economy in
what is referred to as the circular flow of income.
Leakage or Withdrawal refers to those parts of national income that are not used for
consumption. A withdrawal from the circular flow is therefore spending which does not flow
back from household to firms. Injections are supplementary expenditure not originating from
the domestic households.
There are indirect links between saving and investment, taxation and government expenditure,
and imports and exports, via financial institutions, the government (central and local) and
foreign countries respectively. If more money is saved, there will be more available for banks
and other financial institutions to lend out. If tax receipts are higher, the government may be
keener to increase its expenditure. Finally, if imports increase, incomes of people abroad will
increase, which will enable them to purchase more of our exports.
Equilibrium in the circular flow:
In equilibrium, injections are equal to withdrawals. If for example, injections exceed
withdrawals; this will lead to a rise in national income. But as national income rises, so
households will not only spend more on domestic goods (Cd), but also save more (S), pay more
taxes (T) and buy more imports (M). In other words, withdrawals will rise. This will continue
until they have risen to equal injections. At that point, national income will stop rising, and so
will withdrawals. Equilibrium has been reached.
, NATIONAL INCOME DETERMINATION
The level of national income in an economy is determined where aggregate demand equals
aggregate supply. This is also where aggregate expenditure is equal to output. Aggregate
expenditure is the total amount that will be spent at different levels of GDP in a given time
period. It is made up of Consumption C, Investment I, government spending G, and net exports;
that is exports minus imports X-M.
If aggregate expenditure exceeds current output, firms will seek to produce more. They will
employ more factors of production and GDP will rise. Whereas if aggregate expenditure is
below current output, firms will reduce production, so output will change until it matches
expenditure as shown in below figure.
If aggregate expenditure rises, perhaps because consumption and investment increase due to
greater optimism, output will increase. Figure 41.4 shows GDP increasing from Y to Y1.
The level of production in the economy depends on the level of aggregate demand. If people
buy more, firms will produce more in response to this, given that they have spare capacity. If
people buy less, firms will cut down their production and lay off workers. But just how much will
national income rise or fall as aggregate demand changes? We will answer this as we progress.
Looking at the diagram, the consumption of domestically produced goods (Cd) and the three
withdrawals (W) – net saving (S), net taxes (T) and spending on imports (M) all depend on the
level of national income (Y). In fact, in the model, national income must always equal
consumption of domestic goods plus withdrawals: there is nothing else people can do with their
incomes!
Y ≡ Cd +W
Total spending in the economy on the goods and services of domestic firms is defined as
aggregate demand (AD) or Aggregate Expenditure. Aggregate expenditure consists of Cd plus
the three injections (J): investment in the domestic economy (I), government expenditure in the
domestic economy (G) and expenditure from abroad on the country’s exports (X).
AD ≡ AE ≡ Cd + J
In equilibrium, withdrawals equal injections. Since national income (Y) is simply withdrawals
plus Cd, and aggregate expenditure (E) is simply injections plus Cd, it follows that in equilibrium
national income must equal aggregate expenditure.
To summarize:
W= J
Therefore, Cd + W = Cd + J
Y = E (= AD)
Components of Aggregate demand and their determinants
There is a range of influences on how much households spend. The main influence is usually
income and this is why economists study in depth. The rate of interest can affect how much
households spend. Expectations can play a role almost as important as income. The distribution
of income also influences consumption.
Consumption Function
