Circular Flow of Income

Question 1

What is the Circular Flow of Income (CFOI)?

Answer 1

A model that shows how money flows between households and firms in an economy.

Question 2

Who are the two fundamental economic agents in the CFOI model?

Answer 2

Households and firms.

Question 3

What do households provide to firms?

Answer 3

The four factors of production: land, labour, capital, and enterprise.

Question 4

What do firms provide to households in return?

Answer 4

Factor incomes:

Labour → wages/salaries

Land → rent

Capital → interest

Enterprise → profit

Question 5

What do households use their income for?

Answer 5

Consumer expenditure on goods and services produced by firms.

Question 6

What are leakages in the circular flow of income?

Answer 6

Money that leaves the circular flow, including:

Savings (S)

Taxes (T)

Imports (M)

Question 7

What are injections into the circular flow?

Answer 7

Money that enters the flow, including:

Investment (I)

Government spending (G)

Exports (X)

Question 8

What happens if injections > leakages?

Answer 8

The economy grows (expansion in national income).

Question 9

What happens if leakages > injections?

Answer 9

The economy contracts (decline in national income).

Question 10

What is GDP?

Answer 10

Gross Domestic Product – the total value of goods and services produced in an economy in a year.

Question 11

What are the three ways of measuring GDP?

Answer 11

Output method: total value of goods/services produced

Income method: total incomes earned from production

Expenditure method: total spending on final goods/services (C + I + G + (X - M))

Question 12

What is the basic assumption of the simple Circular Flow of Income model?

Answer 12

That all income earned by households is spent on goods and services produced in the economy.

Question 13

Why is this assumption unrealistic?

Answer 13

Because not all income is spent—some is saved, taxed, or used to buy imports. These are leakages from the flow.

Question 14

What are the three leakages in the extended circular flow model?

Answer 14

Savings (S)

Taxes (T)

Imports (M)

(These reduce the flow of income in the economy.)

Question 15

What are the three injections into the circular flow?

Answer 15

Investment (I) – by firms

Government Spending (G)

Exports (X) – foreign spending on domestic goods

(These increase the flow of income.)

Question 16

Which two major sectors are missing from the simple CFOI model?

Answer 16

The Government Sector

The International (Foreign) Sector

Question 17

Why is government spending an injection?

Answer 17

Because it adds money to the economy by purchasing goods and services or through public investment.

Question 18

Why are imports a leakage?

Answer 18

Because spending on imports sends money out of the domestic economy—it’s not spent on domestic output.

Question 19

When is the circular flow of income in equilibrium?

Answer 19

When Total Injections = Total Leakages

(i.e., I + G + X = S + T + M)

Question 20

What does it mean if injections > leakages?

Answer 20

The economy is growing; national income is rising.

Question 21

What does it mean if leakages > injections?

Answer 21

The economy is contracting; national income is falling.

Question 22

What does it mean if I + G + X > S + T + M?

Answer 22

Injections are greater than leakages → economic growth is occurring (expansion).

Question 23

What does it mean if I + G + X < S + T + M?

Answer 23

Leakages are greater than injections → economic contraction is happening (decline).

Question 24

What does it mean if I + G + X = S + T + M?

Answer 24

The economy is in macroeconomic equilibrium—no overall change in income levels.

Question 25

What is GDP?

Answer 25

Gross Domestic Product—total value of all goods and services produced in an economy over one year.

Question 26

Why is GDP a useful economic indicator?

Answer 26

It shows the size of an economy and helps measure economic growth over time.

Question 27

What are the three methods of calculating GDP?

Answer 27

Output method – Total value of goods and services produced Income method – Total income earned (wages, interest, profit, rent) Expenditure method – Total spending: C + I + G + (X − M)

Question 28

Why do all three GDP methods give (roughly) the same result?

Answer 28

Because they measure the same activity (production) from different angles—output = income = spending.

Question 29

What is the expenditure method of calculating GDP?

Answer 29

Total spending on a country’s goods and services in a year: GDP = C + I + G + (X − M) Where: C = Consumer expenditure I = Investment by firms G = Government spending X = Exports M = Imports

Question 30

What is the Aggregate Demand (AD) equation?

Answer 30

AD = C + I + G + (X − M) — it’s the same as the expenditure method of GDP.

Question 31

Why do the three methods of calculating GDP (output, income, expenditure) give the same result?

Answer 31

Because every output sold generates income and is bought as expenditure. So: Output = Income = Expenditure