The Circular Flow of Income


    The Circular Flow of Income

    • The circular flow of income is a model that seeks to explain how the economy works and how changes in AD occur
      • There are two ‘sectors’ – Households and Firms
      • Between these two are the ‘flows’ – income, products, and factor services
      • Households provide factor services and receive factor incomes
      • The factor incomes are then used to buy products produced by firms


    • In practise, not all the income that is earned is spent, as there are additional forms of spending that do not arise in the circular flow
      • There are three ‘leakages’: Taxes (T), Saving (S), and Spending on Imports (M)
      • Leakages reduce AD
    • Injections, on the other hand, increase AD
      • These are: Investment (I), Government Spending (G), and exports (X)
    • Then the value of injections = the value of leakages, there will be no change in output and hence, macroeconomic equilibrium








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