Circular flow of income

Question 1

Define the circular flow of income?

Answer 1

The circular flow of income is a model describing how money (expenditure and income) and goods & services move through an economy, and how an economy arrives at a certain equilibrium level of national output, expenditure and income (GDP)

Question 2

What are the main consumption sectors of the economy?

Answer 2

Household/Consumer (C)
Firms (I)
Government (G)
Foreign Trade (X-M)

Question 3

How does the circular flow of income work?

Answer 3

In a 2-sector economy, all the of income earned by households are spent on firms’ output of goods and service. Consumption expenditure is received by firms as their revenue which they will then make different factor payments. This comprises of wages (labour), rental (land), interest (capital), and profits (entrepreneurship) which allow them to continue production of goods and services to be made and bought.

However, in a 4-sector economy, The government & foreign sector play a role in the flow of income. Only parts of the income will be spent on consumption on domestic goods and services while the rest are set aside for savings (S), payment of taxes (T), and expenditure on imported goods & service (M) from abroad.

Question 4

How do other factors in the 4 sector economy contribute to the flow of income?

Answer 4

Savings, Taxes, and Imports are known as leakages or withdrawals (W), which is a contraction in income in the circular flow for the domestic economy.

An increase in W in terms of S,T,M will result in households spending less of their income on domestically-produced goods. Firms will then produce less and output falls, receiving less revenue to pay factor inputs. Subsequently, output, income and expenditure in the circulation will be lower.

However, Investment (I), Government Expenditure (G) and Exports (X) are known as injections (J) into the circular flow. This adds on/increases the flow of money in the economy through I from financial markets (banks), G by the government sector and C by the foreign sector.

An increase in J will see the domestic economy experiencing an increase in expenditure and firms will hire more factors of production to produce more output, generating more income and in turn spending. Hence, there will be an increase in national output, income, and expenditure in the circular flow.

Question 5

What is the desired level for the economy to reach?

Answer 5

The economy aims to achieve an equilibrium level of real national income

Question 6

How does the economy arrive at an equilibrium level?

Answer 6

Equilibrium level of real national income is reached where there is no tendency for national income to change. Firms have no incentive to increase or reduce production in the net time period when there is no accumulation of inventories and/or no rundown on inventories.

Question 7

What are the conditions for real national income equilibrium?

Answer 7

1. Total spending by the 4 sectors of the economy is equal to the total income earned by factors of production.

If total spending > total income, the economy will expand.
If total spending < total income, the economy will contract.

2. All goods & services produced by firms are bough up by the different sectors of the economy.

If firms produce more than what is bought up, there will an accumulation of inventories, causing firms to reduce production in the next time period, causing the economy to contact in the next time period; vice versa.

3. Withdrawals (W) = Injections (J)

If J > W, national income rises.
If J < W, national income contracts