Understanding the Circular Flow of Income and… | tutor2u Economics
Study notes

Understanding the Circular Flow of Income and Spending

  • Levels: AS, A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

What is the circular flow?

The circular flow of income and spending shows connections between different sectors of an economy

The circular flow model - revision video
  • It shows flows of goods and services and factors of production between firms and households
  • The circular flow shows how national income or Gross Domestic Product is calculated

Businesses produce goods and services and in the process of doing so, incomes are generated for factors of production (land, labour, capital and enterprise) – for example wages and salaries going to people in work.

Leakages (withdrawals) from the circular flow

Not all income will flow from households to businesses directly. The circular flow shows that some part of household income will be:

  • 1.Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit
  • 2.Paid to the government in taxation (T) e.g. income tax and national insurance
  • 3.Spent on foreign-made goods and services, i.e. imports (M) which flow into the economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of production (output)

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.

  1. Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology
  2. The government, i.e. government expenditure (G) e.g. on the NHS or defence
  3. Overseas consumers buying UK goods and service, i.e. UK export expenditure (X)

An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow.

Building up the model

In this next series of images we build up the circular flow model from just having a domestic sector and then adding in an external sector (exports and imports) before including the financial sector which channels savings and hopefully provides the finance available to fund investment.

The Domestic Circular Flow of Income and Spending

The external sector involves businesses exporting goods and services overseas (X) and consumers and business buying imported products from other countries (M)

The domestic circular flow

The Circular Flow of Income and Spending with the External Sector added

Circular flow with external sector

Financial Sector Added to the Circular Flow Model

Test your knowledge: circular flow

Subscribe to email updates from tutor2u Economics

Join 1000s of fellow Economics teachers and students all getting the tutor2u Economics team's latest resources and support delivered fresh in their inbox every morning.

You can also follow @tutor2uEconomics on Twitter, subscribe to our YouTube channel, or join our popular Facebook Groups.

Job board

Economics Contributor

tutor2u, On-line

Related Collections

Teaching Vacancies

Recruitment

Advertise your vacancies with tutor2u

Much cheaper & more effective than TES or the Guardian. Reach the audience you really want to apply for your teaching vacancy by posting directly to our website and related social media audiences.

Find our more ›

Advertise your teaching jobs with tutor2u

A New Home for tutor2u Resources

We've just flicked the switch on moving all our digital resources to instant digital download - via our new subject stores.

For every subject you can now access each digital resource as soon as it is ordered. This will always be the latest edition of each resource too (and we'll update you automatically if there is an upgraded version to use).

Simply add the required resources to your cart, checkout using the usual options and your resources will be available to access immediately via your mytutor2u account.