The Circular Flow of Income

The Circular Flow of Income

This is a basic way of understanding how different parts of the economic system fit together.

The circular flow of income shows connections between different sectors of our economic system. It revolves around flows of goods and services and factors of production between firms and households.

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.

What is GDP?
GDP is Gross Domestic Product. It is the total money value of all final goods and service produced in a country over a period of time. It is calculated using following formula:

GDP = C+I+G+(X-M)

C= Consumption Spending.

I= Investment Spending

G= Government  Spending

X= Export

M= Import

(X-M)= Net Export.

What is GDP Per Capita?
GDP per Capita: GDP divided by the population. Useful for comparing countries & reflects changes in population size..

What is Real GDP and Nominal DGP?

Real GDP: Real GDP is adjusted for inflation rates or inflation adjusted GDP. It is calculated to net out the effect of inflation. Real GDP is calculated at Base Year’s price.

• Remember that if GDP figures from across several years are being compared they should be converted to the prices of the first year under comparison. Strictly speaking they could be converted to the prices of any year but that is just annoying.
• Real % change = Nominal % change – inflation %.
• This allows the total amount of goods and services produced in an economy to be compared over time to determine whether the economy has grown or shrunk.

Nominal GDP or Money GDP: Nominal GDP is not adjusted for inflation rates. Money GDP or Nominal GDP doesn’t net out the effect of inflation. Nominal GDP is calculated at current market price.

• Remember that price increases over time and nominal GDP has not been adjusted for this effect.

What is Economic Growth?

Economic growth is increase in real GDP of an economy over a period of time. An increase in the output (i.e. more goods and services are produced) of an economy as measured over a period of years using the GDP.

An increase in an economy’s productive potential can be shown by an outward shift in the economy’s production possibility frontier (PPF).

The simplest way to show economic growth is to bundle all goods into two basic categories, consumer and capital goods. An outward shift of a PPF means that an economy has increased its capacity to produce.  

What may cause economic growth? Or How an economy can achieve higher level of Economic Growth?

• Increase in the quantity of the factors of production (FoP) available in an economy:
• Increase in the size of the workforce:
• Favorable immigration policies may cause this because with more people immigrating into a nation that nation’s workforce will naturally become larger.
• Higher investment in capital:
• Promotion of R&D may result in this as cheaper machines would then be available.
• Technological advancement.
• Government building better infrastructure.
• This entices firms to move into the nation and allows existing firms to produce more since the costs of production are now lower than before.
• Discovery of previously undiscovered natural resources:
• This, though, usually causes unsustainable growth.

• Improve the quality of FoP:
• A more productive workforce:
• Retraining.
• Better educational standards.
• More productive and efficient capital equipment:
• May be caused by investment in R&D or technological advancements.