Circular Flow of Income Model

A-level Economics

different models of circular flow

 What is the circular flow of income: it shows how money flows throughout the economy between households and firms. It shows the transfer from expenditure to income.

Model A - No Government. Closed Economy. All income spent.

The diagram above shows the most basic circular flow of income model.

1) Money flows from households to firms on the right hand side. This is called expenditure.

2) Firms respond to the expenditure by producing outputs. The more expenditure they receive, the more outputs they will produce.

3) Firms produce these outputs by hiring factor inputs. These factor inputs are land, labour and capital.

4) The firms must pay the factor rewards to the factors of production. This is shown as the flow of income between firms and households on the diagram. This is shown on the left hand side.

This model is very basic. It assumes a few things:

1) There are no governments involved

2) The market is a closed economy. There are no purchases of imports or exports.

3) All income earned is spent

From the diagram above we can also see the following condition is true:

'Expenditure = Output = Income'

How can we show economic growth using this condition?

Any extra money spent will be reflected by extra output that the firms make. And if the firms make extra outputs, they must hire extra inputs and pay extra income. This proves the condition above is true and shows what we need for economic growth to occur. We need firms to be making more output so we need more expenditure and income etc.

Model B: Governments, an Open Economy and some income saved

What makes the above model different?

The above model is a more realistic view of our income. We have governments we pay taxes to, other countries that we buying imports from and we also do not spend all of our money.

Leakages

Do you notice the red lines in the diagram? These red lines are our leakages or withdrawals. This is the money that exits our circular flow. Where does the money go?

• Saving - some of the money is saved by households. They hold back some of their income for future emergencies or future purchases.

• Imports - some of the money is transferred between our circular flow and another country's. Do you see on the diagram how we give money to other countries and it enters their circular flow of income.

• Taxes - some of the money is taxed and transferred to the government. Every country with a government will have a tax law which citizens have to follow.

Injections

Do you notice the bright green lines in the diagram? These are our injections. It is money that enters our circular flow of income.

• Investment - some of this money is invested by firms towards the purchase of capital goods, for example. Capital goods are goods that firms need to make output.

• Exports - some of the money that enters our circular flow is from other countries. It's for our exports. Other countries pay us for these.

• Government Spending - the government can't just tax us and keep all the money, otherwise why would we pay tax? The government uses the taxation money that receive from us, and they spend money on keeping the country running. Things like public services, roads and buildings etc are all funded by the government.

How do we achieve economic growth in this model?

It is very simple. Injections have to be greater than leakages. If injections are greater than leakages that there is a net positive income in our economy and this is what causes GDP growth.

Remember: Expenditure = Output = Income. If 'Income' rises for example, then the others will rise too.

In summary:

• Understand the basic 'Model A'.

• Understand the more realistic 'Model B'.

• Understand how economic growth is achieved.

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