1.1.4 Modelling the economy Notes

Circular flow of income model

At its core, an economy consists of firms and households, which are connected through the economy:

1. Firms generate goods and services, collectively forming the national output.
   1. The national output is the value of all the goods and services generated in an economy.
2. Households provide the factors of production (labor, land, capital, and entrepreneurship) that firms need to produce this output.
   1. The payments households receive by firms for these resources constitute the national income.
3. Households spend the money received from the national income to purchase the goods and services produced by firms.
   1. The total value of this spending represents the national expenditure.

This flow of income can also be represented by the circular flow of income model.

The circular flow of income illustrates how:

1. The factors of production flow from households to firms (upper dashed blue arrow).
2. Firms pay national income to households in return for these resources (solid pink arrow).
3. Households use this income to purchase goods and services from firms as national expenditure (solid blue arrow).
4. Firms supply goods and services to households, forming the national output (dashed pink arrow).

From this, it can be seen how:

1. The national output (value of the total goods and services produced by firms in an economy)...
2. Equals the national income (total income received by the households in producing the economy's output)...
3. Which equals the national expenditure (total spending of households in purchasing the total output of the economy).

Interdependence between economic decision-makers interacting and making choices in an economy

The circular flow of income highlights the relationships and interactions between households and firms in an economy.

Interdependence between households and firms:

1. Households:
   1. Provide the factors of production (labor, land, capital, and entrepreneurship) to firms.
   2. Receive national income in return (wages, rent, interest, and profits).
   3. Use this income for consumer spending on goods and services.
2. Firms:
   1. Use the factors of production to create national output (goods and services).
   2. Sell these goods and services to households, generating revenues.

Leakages and injections:

In an open economy, there are leakages and injections from and into the income flow.

Leakages represent money leaving the circular flow, reducing the size of the economy. Leakages include:

1. Savings: income saved in financial markets instead of being spent.
2. Taxes: paid to the government instead of being used for consumption.
3. Imports: money spent on foreign goods and services.

Injections represent money entering the circular flow, increasing the size of the economy. Injections include:

1. Investment: funds from financial markets used to produce capital goods.
2. Government Spending: expenditures by the government on public services.
3. Exports: foreign spending on domestically produced goods and services.

The figure below showcases the circular flow of income model for an open economy that has leakages and injections: