The Circular Flow of
Income
AQA A Level Economics
Revision Notes
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What national income measures
National income is the total value of the goods and services a country produces. It is
the output in one year.
It can be measured by GDP, GNP and GNI.
Real GDP is the value of GDP adjusted for inflation. For example, if the economy
grew by 4% since last year, but inflation was 2%, real economic growth was 2%.
Nominal GDP is the value of GDP without being adjusted for inflation. In the above
example, nominal economic growth is 4%. This is misleading, because it can make
GDP appear higher than it really is.
Gross National Product (GNP) is the market value of all products produced in an
annum by the labour and property supplied by the citizens of one country. It includes
GDP plus income earned from overseas assets minus income earned by overseas
residents. GDP is within a country’s borders, whilst GNP includes products produced
by citizens of a country, whether inside the border or not.
Gross National Income (GNI) is the sum of value added by all producers who reside
in a nation, plus product taxes (subtract subsidies) not included in the value of
output, plus receipts of primary income from abroad (this is the compensation of
employees and property income).
The circular flow of income
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Firms and households interact and exchange resources in an economy.
Households supply firms with the factors of production, such as labour and
capital,and in return, they receive wages and dividends.
Firms supply goods and services to households. Consumers pay firms for
these.
This spending and income circulates around the economy in the circular flow
of income, which is represented in the diagram above.
Saving income removes it from the circular flow. This is a withdrawal of
income.
Taxes are also a withdrawal of income, whilst government spending on public
and merit goods, and welfare payments, are injections into the economy.
International trade is also included in the circular flow of income. Exports are
an injection into the economy, since goods and services are sold to foreign
countries and revenue in earned from the sale. Imports are a withdrawal from
the economy,since money leaves the country when goods and services are
bought from abroad.
Full employment income is the total output of an economy when
unemployment is minimised or is at the government target. This accounts for
frictional unemployment.
The full circular flow of income can be derived from this:
It is important to remember that income = output = expenditure in the circular
flow.
The effect of changes in injections and withdrawals on national income
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An injection into the circular flow of income is money which enters the
economy.
This is in the form of government spending, investment and exports.
A withdrawal from the circular flow of income is money which leaves the
economy.
This can be from taxes, saving and imports.
The economy reaches a state of equilibrium when the rate of withdrawals =
the rate of injections.
The amount of savings in an economy is equal to the amount of investment. In
the UK, there is a traditionally low savings rate, especially during periods of
high economic growth, and this means that the rate of investment is also low.
In Japan there is a high savings rate and with this comes a high level of
investment.
If there are net injections into the economy, there will be an expansion of
national output.
If there are net withdrawals from the economy, there will be a contraction of
production, so output decreases.
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