Circular Flow of Income GCSE Economics 3.4 Managing the Economy Circular Flow of Income

Learning Outcomes Students should be able to: Demonstrate understanding of the circular flow model Examine how the economic activity of households, firms and the government causes injections into and leakages from the circular flow Examine the effects of these injections and leakages

The Circular Flow of Income The movement of spending and income throughout the economy. It illustrates economic activity in an economy over a given period of time.

National Income Can be measured in three ways: National Output (O) National Expenditure (E) National Income (Y) Output = Expenditure = Income

Different Components of the Circular Flow of Income There are 2 sectors: Households Firms

Factors of Production and Factor Rewards In order to understand the circular flow of income you will need an understanding of the 4 factors of production and their factor rewards Factor of production Factor Income Land Rent Labour Wages Capital Interest Enterprise Profit

The 2-sector Economy This model assumes a closed economy Households Household Expenditure (Consumption) Factor Rewards (Income) Factor Services (LABOUR) Output Firms

Gross Domestic Product The total amount of money earned within an economy is the GDP. GDP is the measure of total output of an economy within a country over a given period of time. GDP can be measured 3 ways.

Measuring GDP and Economic Activity National Output (O) This is the value of the flow of goods and services from firms to households. National Expenditure (E) This is the value of spending (consumption) by households on goods and services. National Income (Y) This is the value of income paid by firms to households in return for land, labour and capital(Factors of production provided). O≡E≡Y

Activity Tasks: Draw a circular flow of income diagram. Label it at the appropriate place with the value of: Income Output expenditure How would your answer be different if wages were £125bn? Table 1 £bn Rent 10 Wages 95 Interest and Profits 20 NB: The figures in Table 1 show all the income payments received by households in the economy. Images © thinkstockphotos.co.uk

Expanding the Circular Flow In reality there are more than just households and firms operating in an economy There is also: Banking - responsible for savings and investment Government – responsible for taxation and spending The economy can also be ‘open’ to international trade in the form of exports and imports

Leakages from the Circular Flow of Income Not all income flows directly from households to firms and vice versa. Some parts of household income will go to: Future spending – in other words saving Paid to the government in taxes. Spent on imports into the economy from other countries These payments for saving, taxation and imports therefore will not be spent in the economy immediately and they become leakages from the circular flow of income.

Injections Into the Circular Flow of Income These flows out of the circular flow of income will be balanced by the fact that there will be flows back into the circular flow of income. These flows are called injections. These may take the form of: Money spent by other firms – also known as investment. Money from the government – in other words government spending. Payment from foreign economies for domestic goods and services - exports

The 4-sector Economy This model assumes an open economy Households Investment Saving Government Spending Taxation Firms Exports Imports

The Impact on GDP of Injections and Leakages When INJECTIONS = LEAKAGES : We have Macroeconomic Equilibrium – there is no change in GDP. When INJECTIONS > LEAKAGES: More money is entering the circular flow than leaving it so there is an increase in GDP INJECTIONS < WITHDRAWALS: More money is leaving the circular flow than entering it so there is a decrease in GDP

Classroom Activity In 2016 the UK’s trade balance deteriorated. Exports rose in this time period, whilst the value of imports increased at a faster rate. Questions: Explain whether exports are a leakage or an injection to the circular flow of income. As a result of this information what would you expect to happen to the level of GDP in the UK economy and why? Stretch and challenge: GDP increased in the UK economy in the same period. Using the components of the circular flow of income, explain why this might be the case.