Monday, 25 July 2011

The Circular Flow of Income (Macroeconomics)

The circular flow of income is basically exactly what it says it is, it shows the flow of income around the economy. It is best shown visually using this diagram:

This diagram shows the circular flow of income around the economy, as well as the flow of goods and factors of production. We can see "Rent, wages and profit" travelling from the firms to households. These are all payments for the factors of production you can see flowing in the opposite direction, from households to firms, next to the arrow. "Payment for goods and services" is flowing from households to firms and as you can see on the arrow next to that, goods and services are travelling in the opposite direction. So from this we can see that money flows around the economy in a circular motion, from firms to households and back to the firms again.

However, this would assume that no more money ever enters or leaves the economy, which we know is almost always untrue. So therefore, we can add a few more things to the diagram. Firstly injections into the economy. Injections means money being put into the economy from an external source. The three main types of injection and government spending, exports and investment. All three of these add additional money into the circular flow of income. Secondly leakages from the economy. This means money that exits the economy for one reason or another. The three main types of leakages are taxation, imports and savings. All these three factors reduce the amount of money in the circular flow of income.

That's it for the basics on the circular flow of income. Thanks for reading, sorry about the delay.

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