1. Economics: Notes for Teachers
Relationship between Total Spending, Total Output and Total Income
Relationship between Total Spending, Total Output and Total Income
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2. Introduction
All economic activity revolves around the production of goods and services (output), the earning of income and the spending of that income (expenditure). In order to examine the relationships between these variables, we make use of an economic model – the circular flow of income model.

3. Circular Flow Model
The full five sector circular flow model demonstrates that the relationship between firms and households is the basis for economic activity.

4. Circular Flow Model
The household sector provides resources, mainly labour and enterprise (real resources) in return for incomes.
The firms provide goods and services in return for expenditure on these items.
Households do not spend all of their income on goods and services. They will save, pay the Government taxes and will purchase goods and services from another system (imports). These are all withdrawals from the circular flow.

5. Circular Flow Model Savings are on lent to business for investment.
The Government sector will expend the funds from taxation.
Domestic goods and services may be sold to other systems and these are known as exports.
When the sum of these injections equals withdrawals, the economy is said to be in equilibrium.

6. Circular Flow Model Y = Income C = Consumption Expenditure S = Savings
I = Investment
T = Taxation
G = Government Expenditure
M = Imports
X = Exports

7. Circular Flow Model Households Firms C S I T M X Y WITHDRAWALS
FINANCIAL MARKET I
WITHDRAWALS
INJECTIONS T
GOVERNMENT G M
OVERSEAS SECTOR X

8. Macroeconomic equilibrium
A situation where the economy has no tendency towards change. Equilibrium exits when the community plans to withdraw the same as firms and government plan to inject.
The economy will move out of equilibrium when the plans of savers and investors differ. There is no reason why these plans should be the same.

9. Macroeconomic equilibrium
When planned injections are greater than planned withdrawals, there will be a running down of inventories. This will lead to an increase in output which in turn will cause employment to rise and national income to increase.
When injections are less than withdrawals, inventories will rise leading to a fall in production, employment and national income. The change in national income will be greater than the initial change in the difference between injections (J) and withdrawals (W).

10. Macroeconomic equilibrium
Equilibrium in the circular flow model can be illustrated using the Keynesian Cross diagram below:
The 45° line plots the points where output, income and expenditure are equal. It is known as the line of absolute equity. The AE line indicates the amount of spending undertaken by the economy at different levels of income.
Aggregate
Expenditure
45°
Equilibrium
O > E AE
E > O
Income/
Output

11. Macroeconomic equilibrium
At levels of income below equilibrium, expenditure will exceed total output. Stocks will diminish and production will increase, tending the economy towards equilibrium.
At income levels above equilibrium, output is greater than expenditure. Stocks will rise and production will fall causing the economy to tend downwards towards equilibrium.
For the equilibrium level of income to change, there will have to be a change in aggregate expenditure at all levels of income.

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