1. ECON2: The National Economy
2.3 Circular Flow of Income
How does money move around the economy?
In what ways can this flow of money increase?
In what ways might this flow decrease?
ECON2: The National Economy

2. The concept of the circular flow of income
2.3 What you need to know
The concept of the circular flow of income
How the circular flow of income might become larger or smaller
The equation income = output = expenditure
The term macro-economic equilibrium

3. Understand and explain why income = output = expenditure
2.3 You should be able to:
Understand and illustrate the concept of the circular flow of income on a diagram
Identify the different injections and withdrawals that might impact the size of the circular flow of income
Understand and explain why income = output = expenditure
Explain clearly the concept of macro-economic equilibrium

4. The Circular Flow of Income: A Definition
“An economic model showing the flow of goods and services, the factors of production and their payments between households and firms within an economy.”
Imagine you spend £10 in a shop, where do you think it goes?
Draw a flow chart of how you think that £10 may spread around the economy.

5. A Simple Model
The UK economy is very complex and operates in a global environment, so initially we are going to simplify the model
We are going to assume the economy is “closed”
This means there is no foreign trade and no government influence
This means there are only 2 groups
Households
Firms

6. A Simple Circular Flow of Income
Households
1) Firms provide households with goods and services
2) Households spend their income on the goods and services produced by firms
4) In order to pay for these factor services, firms pay households rent, wages, interest and profit
3) Households also provide firms with factors of production:
Land, Labour, Capital & Entrepreneurship
Firms

7. Capital = For investment Rent = For Land Wages = For Labour
Key Terms
Land = For buildings
Labour = For output
Capital = For investment
Rent = For Land
Wages = For Labour
Interest = For Capital
Profit = For Entrepreneurship

8. THIS IS CLEARLY UNREALISTIC – WHY?
Assumptions
This simple model makes a number of assumptions
Households spend all their income on goods and services
Firms spend all their income on factors of production
There is no government
There is no foreign trade
THIS IS CLEARLY UNREALISTIC – WHY?

9. A More Realistic Model
We need to take into account a more realistic role of all the participants in the circular flow
To do this we consider INJECTIONS into and WITHDRAWALS from the circular flow
Do you think the following are injections or withdrawals from the circular flow of income?
Savings
Investment
Exports
Government Spending
Taxes
Imports

10. Government Expenditure
A More Realistic Model
Households
WITHDRAWALS
INJECTIONS
Savings
Taxes
Imports
Government Expenditure
Investment
Exports
Firms

11. For each of the following examples, decide whether the circular flow of income will increase or decrease in size
Event
Increase or Decrease
The rate of VAT increases
Tax breaks are given to new start-up businesses
The pound strengthens against the Euro
Interest rates are cut
Workers become nervous about keeping their jobs

12. Measuring National Income
There are three different methods of calculating the level of national income in an economy
Income Method
Output Method
Expenditure Method

13. Measuring National Income
In theory, these 3 methods will always equal each other
Example:
If a firm produces a unit of output and sells it for £100, it can be said that the value of that output is £100
Therefore, it follows that the firms income will be £100
Logically, it must also follow that the customer has provided £100 of expenditure
Therefore:
income = output = expenditure

14. Macroeconomic Equilibrium
This will be covered in 2.4 in more detail
Macroeconomic equilibrium occurs when the demand-side of the economy and supply-side of the economy equal each other
This means that everything that has been produced by firms, has been purchased and consumed by households
In macro-economic equilibrium there is no excess demand or excess supply

15. Government spending, Imports, Taxes Savings, Exports, Taxes
Multiple Choice 1
Which combination of the following are withdrawals from the circular flow of income?
Government spending, Imports, Taxes
Savings, Exports, Taxes
Savings, Imports, Taxes
Imports, Exports, Saving
Can you explain your answer? C

16. Can you explain your answer?
Multiple Choice 2
Which of the following is most likely to cause an increase in the size of the circular flow of income? An increase in
investment
tax revenue
imports
saving
Can you explain your answer? A

17. Understand and explain why income = output = expenditure
2.3 You should be able to:
Understand and illustrate the concept of the circular flow of income on a diagram
Identify the different injections and withdrawals that might impact the size of the circular flow of income
Understand and explain why income = output = expenditure
Explain clearly the concept of macro-economic equilibrium