1. Circular Flow of Income

2. Lesson Objectives To understand what the circular flow of income is
To learn what it contains
To understand why we measure nations’ (flow of) income
To appreciate that wealth and income are not the same

3. The circular flow of income
Households
Rent,
wages,
interest
and profit
Land, labour and capital
Expenditure
on goods
and services
Goods and services
Firms
This is a simple model – a CLOSED economy – where there is no foreign trade

4. The circular flow of income
Households
Rent,
wages,
interest
and profit
Land, labour and capital
Expenditure
on goods
and services
Goods and services
Firms
Based on this model, there are three ways of measuring the level of economic activity

5. Measuring the level of Economic Activity
National Output (O) – the value of the flow of goods and services from firms to households
National Expenditure (E)– the value of spending by households on goods and services
National Income (Y) – the value of income paid by firms to households in return for land, labour and capital
O E Y

6. Injections and Withdrawals
The circular flow of income highlights the main injections and withdrawals in an economy.
Injections will add money to the circular flow of income; they raise spending.
Withdrawals will remove money from the circular flow; they reduce spending.

7. Injections and Withdrawals
Households
Withdrawals
Saving
Taxes
Imports
Injections
Investment
Government Spending
Exports
Income
Expenditure
Firms

8. What does this all mean?
If injections are greater than withdrawals, expenditure on goods and services will exceed the planned level of production. Firms will, therefore, expand output and national income will rise.
However, if withdrawals are greater than injections, production will exceed the current level of expenditure. Firms will, therefore, reduce their output and national income will fall.

9. Measuring National Income
Different measures are used to calculate national income
The best known measure is GDP
This increases the actual value of national income because it includes indirect taxes such as VAT
There are other measures of national income, but GDP remains the best guide to economic performance both over time and between countries

10. Activities Questions 1 (a) and (b) on page 162

11. Question 1: p.162 Households Firms £bn Rent, 5 Expenditure
Wages interest
and profit
Total
Expenditure
on goods £100 bn
and services
£125 bn
£100 bn
£125 bn
Firms

12. Question 3 (b): p.163
Economists test hypotheses and build economic models. E.g., an economist might suggest that high investment leads to high per capita income. This could be tested by correlating statistics for 2 different economies.
Both economists and governments can make policy recommendations based upon economic evidence. E.g. if transferring resources from richer to poorer nations, who should gain and who should lose?
Economists and governments are also interested in making judgments about economic welfare. GNP per capita figures are an important measure of living standards.
Figure 4 shows comparisons between countries which are relatively easy to understand.

13. Homework
Read the section ‘Accuracy of national income statistics’ (pages 163-4)
Answer question 4 on page 164
Read and make notes on the rest of pages 164 and 165
Answer question 5 on page 164