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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

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