Circular Flow of Income1

1
The Circular Flow of Income
2
Intro Economic Models

• In order to explain or predict what might happen
  in the economy economists create economic models.
• Models are simplified ways of explaining how
  something works
• These vary from the very simple to very complex
• You have already come across the PPF as a model
  of the economy
• Now you will look at the circular flow model
  which looks at how money flows around the
  economy.
• We will build it up bit by bit, starting with a
  very simple version of the economy and gradually
  making it more complicated

3
The Circular Flow of Income
Consumer Spending

• There are only 2 groups in the economy
• Households
• Firms
• Firms supply households with goods and services,
  for which they receive payment
• Households provide firms with labour, for which
  they receive wages.
• This money is then spend on goods and services
  provided by firms and the cycle continues

Wages
4
The Circular Flow of Income
Of course households dont actually have to
spend all their income. Now we introduce
saving Households save in banks Banks lend to
firms who use this money to invest Households
reward for this is interest (of course
households can borrow to but this goes straight
back to households so we ignore it.)
C
Investment
Firms
Households
Lending
Saving
Wages
Wages Interest
5
The Circular Flow of Income
The other component of most household expenditure
is tax Government taxes both households and
firms. Some of this money is returned to
households through benefits The rest of the
government income is spent on goods and services
(govt spending)
I

Govt
C
Spending
Investment
Tax Benefits
Tax
Firms
Households
Lending
Saving
Wages Interest
6
The Circular Flow of Income

-
X
G
M

Exports
I
So far we have assumed there is no trade in the
economy (sometimes called autarky) NB we are
following money NOT goods Imports take money
out of the economy Exports bring money into the
economy.

C
Govt
Imports
Spending
Investment
Tax Benefits
Tax
Firms
Households
Lending
Saving
Wages Interest
7
The Circular Flow of Income

-
X
M
G

The only thing missing now is the remainder of
household income. Remember households supply all
the factors of production This means that they
must receive payment for each one We already
have Labour Wages Capital Interest
(money lent to invest
in capital) We need to add Land Rent
Enterprise - Profit
I

Govt
C
Spending
Investment
Tax Benefits
Tax
Firms
Households
Lending
Saving
Rent Wages Interest Profit
Wages Interest
8
The Circular Flow of Income

-
X
M
G

The only thing missing now is the remainder of
household income. Remember households supply all
the factors of production This means that they
must receive payment for each one We already
have Labour Wages Capital Interest
(money lent to invest
in capital) We need to add Land Rent
Enterprise - Profit
I

Govt
C Consumer spending I Investment G
Government Spending X Exports M - Imports
C
Spending
This is total demand in the economy, also called
Aggregate Demand. Remember this we will come
across it later.
Investment
Tax Benefits
Tax
Firms
Households
Lending
Saving
Rent Wages Interest Profit