### THE CIRCULAR FLOW OF INCOME

THE CIRCULAR FLOW OF INCOME
There should be an understanding of the circular flow of income concept, the equation income = output = expenditure, and of the concept of macroeconomic equilibrium.

Note: candidates are not expected to have a detailed knowledge of the
construction of national income accounts.

Watch the video presentation or read the text version below.
The circular flow of income is a macroeconomic model of the whole economy and it can be represented as a simple two-sector model, or it can be built up in complexity and realism by the addition of different sectors. It would be helpful to recall that Gross Domestic Product (GDP) is the total level of spending in the economy or aggregate demand AD.

We start with the simplest form of the model, imagine I spend £50 on a chair – lets call this expenditure. This expenditure of £50 must mean the chair is worth £50, so we can also say that the output of the economy is £50 –the value of what is bought must necessarily be the value of what is sold – i.e. the output.

What happens to the £50 that firms receive from selling their output – well they have to pay for the land, labour and capital they use to produce it and if there is anything left over the entrepreneur gets a profit – so all of the £50 ends up with people one way or the other - so what people earn is also the same as the value of their output which is the same as their expenditure - so now we can say that the value of expenditure, output and income are all the same. If we measure the economy by adding up what people earn it should equal the value of what retail sales are, and this should also be the same as the total value that each firm adds to a product as it goes through the chain of production. The two-sector model
Another way of demonstrating the circular flow model is with a simple two-sector model. The two sectors consist of households and firms. Households provide to firms their land, labour, capital and enterprise and in return they receive rent, wages, interest and profit which together is the households income, lets use the letter Y to represent this.
The two-sector model is also seen in a slightly different version. Again we have households and firms – households spend their money with firms, which we call expenditure and we use the letter E for this. Firms give rent, wages interest and profit to households – together this is the household’s income and remember we use the letter Y for this – we use Y because later we will use the letter I for something else. The goods and services bought by households is the output and we give this the letter O.

In this model expenditure and income are equal, everything that is earned is spent, and because E is just the total of expenditure we can just as reasonably call E aggregate demand – so we can say AD = E. And as long as E and Y are equal the economy will stay in equilibrium and there is no pressure for it to grow or shrink.

However, the two-sector model is a poor representation of how things really are. We can make the model more realistic by showing that some money leaks out of the economy or as some textbooks say is withdrawn. When households earn their income they don’t actually spend all of it – some goes into savings accounts or pension funds, in economics, income that is not spent is called savings. These savings are deposited into the financial sector, so we now have a three-sector model.

The three sector model
Because E no longer = Y we need to change the model a little, expenditure is replaced with the word consumption and we use the letter C for this. Because consumption is less than income the economy will start shrinking – firms are getting less and can’t pay their workers as much so Y shrinks too – theoretically if people keep saving, their income will keep on falling too, and in the end their will be no spending and no income and with no income their will be no saving either – this situation was named by John Maynard Keynes as the paradox of thrift. This paradox is that if planned savings are greater than investment the economy shrinks, and with a shrunken economy incomes shrink too, which means that actual savings will paradoxically be much lower than planned savings.

However – the money saved in financial institutions isn’t just left there, firms borrow from the banks and pension funds and invest in their businesses. Investment in economics means, spending on capital goods such as new machinery, which is not the same thing as buying stocks and shares which is just a form of moving money about.

When firms invest in the economy, the economy expands and there is a corresponding increase in wages and salaries, so incomes increase, and because incomes rise then consumption increases too. Hopefully you should see that if investment is larger than savings the economy grows, and if saving is greater than investment the economy shrinks. At equilibrium where investment and savings are equal the economy is stable. We can now write an equation to show that aggregate demand equals the total amount of spending, AD = C + I.

The four sector model
Of course this three-sector model is still a little simplistic. Not only do households save some of their income –some of it gets used to pay taxes, be it income tax, VAT or something else.

By adding a fourth government sector we add another layer of complexity. If taxes disappeared down a black hole, the economy would shrink, just as it did if when savings were greater than investment in the three-sector model. However the other side of the taxes coin is government spending which is injected into the economy just as investment was. John Maynard Keynes wrote in 1936 that in a depression it was possible that planned savings would exceed investment and the economy would shrink and this would in turn result in mass unemployment. And although there might be equilibrium in the goods and services market, the labour market might exist in a state of disequilibrium where the supply of labour was greater than the demand for it because overall there was a low level of aggregate demand. In this situation firms would lack confidence and be unwilling to invest so the problem would persist for a long time. The solution to the problem would be for the government to raise spending above the level of taxation so that the increased injections would get the economy to grow. If necessary the government, Keynes said, would have to borrow the money to get the labour market back into equilibrium.
Now the total amount of spending or aggregate demand equals consumption, investment and government spending. AD =C+I+G.

The five-sector open model
So far our model has been a domestic model. By adding a fifth sector we open the model up to the world, and this five-sector model is sometimes referred to as being an open model. With the financial and government sectors the flow of income, went into the financial and government sectors in the form of savings and taxes, flowed through the system and was injected back in the form of investment and government spending.

However, with the addition of an overseas sector – money leaks out of the system entirely in the form of money spent on imports for which we use the letter M. Although the pounds that flow out will eventually flow back in as ultimately foreigners can’t do anything with these pounds other than buy something from us, however they might not spend these pound immediately – so in any time period there is no reason why money spent on imports should equal that earned from the sale of exports (which we use the letter X for) This complicates our formula a little as we must look at the net spending on our exports (X-M)
In this final 5 sector model – I have shown that expenditure or aggregate demand is made up of consumption, investment, government spending and net spending on exports. Finally we arrive at one of the most import ant equations in economics and one you need to know by rote.

Together the money that leaks out of the circular flow is called leakages or sometimes withdrawals and the small letter w is useful here. Investment, government spending and exports are collectively called injections and the small letter j is sometimes used. If planned injections are larger than planned withdrawals then the economy grows but if planned withdrawals are larger than planned injections the economy shrinks. If planned injections and planned withdrawals are the same then actual injections and leakages ail be equal too, and the economy neither grows nor shrinks.

#### IN OTHER WORDS,

National income, output, and expenditure are generated by the activities of the two most vital parts of an economy, its households and firms, as they engage in mutually beneficial exchange.
Households
The primary economic function of households is to supply domestic firms with needed factors of production - land, human capital, real capital and enterprise. The factors are supplied by factor owners in return for a reward. Land is supplied by landowners, human capital by labour, real capital by capital owners (capitalists) and enterprise is provided by entrepreneurs. Entrepreneurs combine the other three factors, and bear the risks associated with production.
Firms
The function of firms is to supply private goods and services to domestic households and firms, and to households and firms abroad. To do this they use factors and pay for their services.

### Factor incomes

Factors of production earn an income which contributes to national income. Land receives rent, human capital receives a wage, real capital receives a rate of return, and enterprise receives a profit.
Members of households pay for goods and services they consume with the income they receive from selling their factor in the relevant market.
Production function
The simple production function states that output (Q) is a function (f) of:  (is determined by) the factor inputs, land (L), labour (La), and capital (K), i.e.
Q = f (L, La, K)

The Circular flow of income
Income (Y) in an economy flows from one part to another whenever a transaction takes place. New spending (C) generates new income (Y), which generates further new spending (C), and further new income (Y), and so on. Spending and income continue to circulate around the macro economy in what is referred to as the circular flow of income.
The circular flow of income forms the basis for all models of the macro-economy, and understanding the circular flow process is key to explaining how national income, output and expenditure is created over time.
Injections and withdrawals
The circular flow will adjust following new injections into it or new withdrawals from it. An injection of new spending will increase the flow. A net injection relates to the overall effect of injections in relation to withdrawals following a change in an economic variable.

## Savings and investment

The simple circular flow is, therefore, adjusted to take into account withdrawals and injections. Households may choose to save (S) some of their income (Y) rather than spend it (C), and this reduces the circular flow of income. Marginal decisions to save reduce the flow of income in the economy because saving is a withdrawal out of the circular flow. However, firms also purchase capital goods, such as machinery, from other firms, and this spending is an injection into the circular flow. This process, called investment (I), occurs because existing machinery wears out and because firms may wish to increase their capacity to produce.

## The public sector

In a mixed economy with a government, the simple model must be adjusted to include the public sector. Therefore, as well as save, households are also likely to pay taxes (T) to the government (G), and further income is withdrawn out of the circular flow of income.
Government injects income back into the economy by spending (G) on public and merit goods like defence and policing, education, and healthcare, and also on support for the poor and those unable to work.