Circular Flow
1. Explain the functioning of the Circular Flow of Income.
The Circular Flow of Income is a model that indicates how money moves throughout an economy. This model was mainly in use up to the Second World War and is a model developed by classical (monetarist) economists. Many models have been developed based on The Circular Flow of Income.
The Circular Flow of Income consists of two parts, the inner circular flow and injections and withdrawals. In the inner circular flow there are two basic economic institutions, these are firms and households and these have an economic interaction. The following diagram shows the inner circular flow of income:
The model shows that firms pay money to households in the form of factor payments. In other words, they pay households wages, dividends on shares, interest and rent in return for labour, capital and land. They do this in order to maintain their production. Households then use this income to pay firms for the consumption of domestically produced goods and services (Cd) thus completing the circular flow. If households spend all of the income they receive on Cd and firms in turn spend all of their income on factors of production then the flow will just continue indefinitely.
However, in the real world households will only use a proportion of their income for Cd. Some of households’ money is withdrawn from the economy as households save money for the future, lose part of their earnings in taxation, and in an open economy they spend money on imports. Furthermore, only part of the income firms receive is from Cd, there is also income for firms from outside of the inner flow as governments spend on public goods, banks make loans to firms and individuals for investment, and some domestic goods are exported abroad. Here is the model including injections and withdrawals.
There are three types of withdrawals from the inner flow. Households will save a proportion of their income in
The Circular Flow of Income is a model that indicates how money moves throughout an economy. This model was mainly in use up to the Second World War and is a model developed by classical (monetarist) economists. Many models have been developed based on The Circular Flow of Income.
The Circular Flow of Income consists of two parts, the inner circular flow and injections and withdrawals. In the inner circular flow there are two basic economic institutions, these are firms and households and these have an economic interaction. The following diagram shows the inner circular flow of income:
The model shows that firms pay money to households in the form of factor payments. In other words, they pay households wages, dividends on shares, interest and rent in return for labour, capital and land. They do this in order to maintain their production. Households then use this income to pay firms for the consumption of domestically produced goods and services (Cd) thus completing the circular flow. If households spend all of the income they receive on Cd and firms in turn spend all of their income on factors of production then the flow will just continue indefinitely.
However, in the real world households will only use a proportion of their income for Cd. Some of households’ money is withdrawn from the economy as households save money for the future, lose part of their earnings in taxation, and in an open economy they spend money on imports. Furthermore, only part of the income firms receive is from Cd, there is also income for firms from outside of the inner flow as governments spend on public goods, banks make loans to firms and individuals for investment, and some domestic goods are exported abroad. Here is the model including injections and withdrawals.
There are three types of withdrawals from the inner flow. Households will save a proportion of their income in
References: -Garret, D. Sloman, J. Wride, A. (2012), Economics Eighth Edition, Chapter 20: Fiscal and Monetary Policy page 586, Pearson Education. -Garret, D. Sloman, J. Wride, A. (2012), Economics Eighth Edition, Chapter 20: Fiscal and Monetary Policy page 630, Pearson Education. - HM Government (2010), The Coalition: Our Programme for Government, 9. Deficit Reduction page 15, Crown copyright, http://www.direct.gov.uk/prod_consum_dg/groups/dg_digitalassets/@dg/@en/documents/digitalasset/dg_187876.pdf, site visited 05/12/2012. -Garret, D. Sloman, J. Wride, A. (2012), Economics Eighth Edition, Chapter 20: Fiscal and Monetary Policy figure 20.12 page 621, Pearson Education. -Garret, D. Sloman, J. Wride, A. (2012), Economics Eighth Edition, Chapter 20: Fiscal and Monetary Policy page 620, Pearson Education. -Garret, D. Sloman, J. Wride, A. (2012), Economics Eighth Edition, Chapter 20: Fiscal and Monetary Policy page 621, Pearson Education.