Circular flow of income

1. Circular Flow
Dr Navneet Gera

2. Circular Flow of income
An economic model which describes the
reciprocal circulation of income between
producers and consumers.[

3. Assumptions of a basic circular flow of
income
• two sectors: households and firms.
• Households spend all of their income (Y) on goods and services(C).
There is no saving (S).
• All output (O) produced by firms is purchased by households
through their expenditure (E).
• There is no financial sector, government sector and overseas
sector.

4. FIRMS
(suppliers of goods and services,
demanders of factor services)
HOUSEHOLDS
(demanders of goods and services,
suppliers of factor services)
The interdependence of goods and factor markets

5. The Simple Circular Flow

6. Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
The circular flow of income
Inner
flow

7. A reality - Withdrawals
• ‘S’- Net savings = Savings – borrowings
• ‘T’ Net taxes = Total taxes - benefits(transfer payments)
• ‘M’ Import expenditure
W=S + T + M

8. A reality - Injections
• ‘I’ Investment – in plant and equipment, inventory stock
• ‘G’ Government expenditure
• ‘E’ Export
J = I + G +X

9. Relationship between withdrawals and
injections
Indirect links between
• Savings & Investment - through financial institutions
• Taxes and govt expenditure – through govt
• Imports and exports – through foreign countries

10. Cases between injections and withdrawals
• Planned injections = Planned withdrawals
• Planned injections > Planned withdrawals and level of expenditure
will rise → Extra AD →extra incomes→ effects on four macro
economic objectives will be
• ↑ EG - ↓ unemployment
• ↑ inflation - ↑in imports ↓ in exports
• Planned injections < Planned withdrawals - ?

11. Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
BANKS, etc
Investment (I)
Net
saving (S)
The circular flow of income

12. Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
BANKS, etc GOV.
Investment (I)
Government
expenditure (G)
Net
saving (S)
Net
taxes (T)
The circular flow of income

13. Factor
payments
Consumption of
domestically
produced goods
and services (Cd)
BANKS, etc GOV. ABROAD
Investment (I)
Government
expenditure (G)
Export
expenditure (X)
Net
saving (S)
Net
taxes (T)
Import
expenditure (M)
The circular flow of income
WITHDRAWALS
INJECTIONS

14. Distinguishing Between Nominal
and Real Values
Real Values
Measurements after adjustments have been made for changes in the
average of prices between years

15. Distinguishing Between Nominal
and Real Values
• Correcting GDP for price index changes
• Nominal (current) dollars GDP
• Real (constant) dollars GDP
*Price level: measured by the GDP deflator
Real GDP = = 100
nominal GDP
price level*

16. Total expenditure = Aggregate Demand
(AD) - Recap
• AD is the sum of the final expenditure on UK produced goods and
services measured at current market prices
• The full equation for GDP using this approach is
GDP = C + I + G + (X-M)

17. GDP and the standard of living
• GNP per head- per capita GNP or per capita income
Standard of living = Real national income/Population
• A high standard of living means households consume a large
number of goods and services