Circular Flow of Income
- The circular flow of income is to show flows of goods and services and factors of production between firms and households. It used to measure the level of income and output in the economy . Households provide resources which aid the production process of business firms. Resources such as labour, land and capital are used by the business firms in return for payment this generates a flow of income to the households in the form of wages, rent, interest and profit . Firms in return make using the factors of productions goods and services which are sold to the households.
Households give back payment for the goods and services these are expenditures. Expenditure of households becomes income for firms. The firms then spend this income on factors of production such as labour, capital and raw materials, “transferring” their income to the production factor owners. The production factor owners then spend this income on goods and services provided by the business firms which leads to a circular flow of income.
- The income and spending of the circular flow of income are not equal this is because of injections and withdraws from the economy.
Injections provide finance into the economy whilst withdrawals is money taken out of the economy. If withdrawals are bigger than injections the country would be facing a deficit and negative economic growth. If withdrawals are less than injections then a country would be facing a budget surplus and economic growth.
- Injections
- Investment (I)
- Government spending (G)
- Foreign money /Exports (X)
- Investment (I) is defined as spending that results in an increase the economy’s capital stock .
Successful investments result in a increase in the economy’s capacity to produce goods and services increasing profit. Examples include spending on construction and property the values of which appreciate over time due to inflation. The average, household spends less each year than they receive in income. The portion of household income that is not used to buy goods and services or to pay taxes is Savings (S). The most familiar form of saving is the use of part of a households income to make deposits in bank accounts or to buy shares or bonds, rather than to buy goods and services.
The government withdrawals money, collecting revenue through taxes (T) which is provided by households and firms to the government. Taxes such as income tax that is tax on wages or corporation tax that is the tax on business profits are withdrawn out of the current income reducing the expenditure on current goods and services. Taxes are then injected back in as government spending (G) they are used to provide services such education, NHS and to provide welfare payments to the community such as jobseekers allowance, housing benefit and disability living allowance.
International trade plays an increasingly important role in shaping the performance of the British economy, the UK is seen as one of the world leaders in terms of the volume of imports/ exports of commodities and services. The value of exports (X) sold overseas will be injected into the circular flow, one of the UK’s largest exports is pharmaceuticals. Spending by UK consumers and businesses on imported (I) products represent a leakage from the flow, over 60% of imports into Britain are finished manufactured goods, while just under 3% are basic materials such as tobacco for cigarettes.
