The circular flow of income

The circular flow of income is an economic model that allows us to demonstrate how an economy works.  We will model how money flows around an economy; this includes our exports and imports to and from other countries.


A Simple Circular Flow Model

We will start by looking at a very simplified economy and analyse the flows of money.  After their boat sank four families have found themselves stranded on a desert island.  The diagram below summarises the flows of money in the desert island economy.


Initially there is only £5 on the island and it is held by Family A.  They spend the £5 with family B in return for goods and services, who in turn spend £5 on goods and services from household C, who visit family D and buy £5’s worth of goods and services and then, finally, the £5 returns to family A in exchange for goods and services.


The total value of the total value of goods and services produced for the island, the National Output, is £20.  The total value of earnings on the island, the National Income, is £20.  The total value of spending in the economy, National Expenditure, is also £20.


We can see from this simplified model that the Gross Domestic Product can be written as:


GDP = National Output = National Income = National Expenditure


Two-Sector Economy

In a two-sector economy we add in businesses to the economy.


Households own the factors of production which businesses are able to use in return for payment.


Households have two options of what to do with their income – spend or save.  There is a positive relationship between income and savings; as income rises, so does savings.


Only businesses can invest; it is important that you don’t state that households invest their money – households save.

Three-Sector Economy

In a three-sector economy we add in the government to the economy.


For the same of simplicity we show all taxes leaving the circular flow of income at the same point, even though some taxes are paid by businesses.


These benefits, or transfer payments as we call them, are not counted as government spending – we count them as a negative tax.  Benefits are , in effect, the transfer of money from one household to another.


Four-Sector Economy

In a four-sector economy we add in the foreign sector to the economy.


The diagram might give the impression that savings=investment, taxes=government spending, and imports=exports; it is important to note that this isn’t necessarily the case.  The decisions to save and invest are taken by different groups; therefore we would not expect them to match.  The same applies for the other withdrawals and injections.


The size of the withdrawals (savings, taxes and imports) will increase when household income rises.


Disequilibrium and Equilibrium in the Circular Flow

If injections are greater than withdrawals it will lead to the level of national income increasing as money enters the circular flow.  This increase in income will lead to households not only consuming more, but also increasing their savings, the amount of taxes they have to pay and the number of imports they buy.  Withdrawals will continue to rise until they equal injections – at this point equilibrium will have been reached.


Measuring GDP

Remember when we were looking at the four families living on the beach and we stated

GDP = National Output = National Income = National Expenditure

as the amount produced, spent and earned all equalled the same amount.  The same principle can be applied to the whole economy.  The amount produced equals income equals expenditure, as seen below.



The ONS explanation
How ONS statistics explain the UK economy

Infographic by Office for National Statistics (ONS)

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