Circular Flow of Income


    Assume a simple model of the economy with just households and firms, there is no government and no foreign trade. Households own the factors of production (land, labour and capital) and supply these to firms in return for income (rent, wages and profit). Households spend all of their income on goods and services. Firms use the factors of production to produce goods and services and sell these to households. Firms spend all of their revenue on the factors of production.

    Adding banks (saving and investment), the government (government spending and taxes) and foreign trade (exports and imports) to the model, the circular flow now shows injections and leakages. An injection into the circular flow is money coming into the economy. Injections include:

    – Investment

    – Government Spending

    – Exports A leakage from the circular flow is money leaving the economy. Leakages include:

    – Saving – Taxes – Imports

    An increase in injections makes AD, income and output rise because there is more money flowing around the circular flow. An increase in leakages makes AD, income and output fall because there is less money flowing around the circular flow. At equilibrium, AD, income and output do not change.

    Income and Wealth Income is a flow of money that an agent receives between a period of time. Wealth is a stock of assets that an agent owns at any one point in time. An agent’s wealth can include houses, stocks and shares. Wealth generates a flow of income for example a house can earn rent, stocks and shares can earn dividends and profit.



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