Syed Muzahir Abbas Shah
ISL, BDC, BLL, SICAS, LGS
4.2 Introduction to the circular flow of income
The circular flow of income and spending shows connections
between different sectors of an economy. It shows how money flows
through the economy in a constant loop between the four main
sectors of an economy.
There are four key components of the circular flow:
Households:
Households receive income through wages and salaries from
their jobs and investments and they can buy goods and services
supplied by firms (consumer spending)
Firms:
They hire land, labour & capital inputs when making products
for which they pay wages and rent. Firms receive payment from
consumers creating revenue and profits.
Government:
Government collects taxes (T) to fund spending on public
services e.g. education, healthcare and defence etc. State or
government spending is labelled as G.
Net Exports:
A country buy imports (M) from other countries; and overseas
businesses and consumers buy our products, known as exports
(X).
AS MACRO 1
Syed Muzahir Abbas Shah
ISL, BDC, BLL, SICAS, LGS
4.2.2 Injections and Leakages
Injections:
This represents the money entering the economy. When
injections are greater than withdrawals the amount of money
in the economy increases, resulting in economic growth. There
are three types of injections which include:
Investment
Government Spending
Exports
Withdrawals:
This is money which is leaving the economy. When withdrawals
are greater than injections, the amount of money in the
economy decreases, resulting in a fall in real GDP. There are
three types of withdrawals which include:
Savings
Taxation
Imports
AS MACRO 2
Syed Muzahir Abbas Shah
ISL, BDC, BLL, SICAS, LGS
National Income equilibrium is where withdrawals (W) and
Injections (J) are equal to each other. This is a point where there is
no tendency for a change in national income. There are two methods
of determining national income equilibrium.
(I) W=J
(a) S=I 2 Sector Economy
(b) S+T= I+G 3 Sector Economy (Closed)
(c) S+M= I+X 3 Sector Economy (Open)
(d) S+T+M= I+G+X 4 Sector Economy
(II) AE=Y
(a) AE= C+I=Y 2 Sector Economy
(b) AE= C+I+G=Y 3 Sector Economy (Closed)
(c) AE= C+I+(X-M)=Y 2 Sector Economy (Open)
EXAMPLE:
AS MACRO 3
Syed Muzahir Abbas Shah
ISL, BDC, BLL, SICAS, LGS
Equilibrium occurs where Injections = Leakages
A disequilibrium will be where injections and withdrawals are
not equal. In this case, Disequilibrium is at A as both
withdrawals and injections are not equal to each other at this
point.
Quick Revision:
When Injections > Leakages, NY will expand
When Leakages > Injections, NY will contract
1.
2.
AS MACRO 4
Syed Muzahir Abbas Shah
ISL, BDC, BLL, SICAS, LGS
Assess whether an increase in investment in new infrastructure
projects will always have a positive impact on the circular flow of
income in an economy. [12]
Responses may include:
AO1 Knowledge and understanding and AO2 Analysis (max 8 marks)
Increased investment in new infrastructure can have a positive and negative impact
on the circular flow of income in an economy:
Increased investment can be from firms or government
Household savings can be a source of funds for this investment
Investment is an injection in to the circular flow of income
There is increased payments for factors of production.
Households supply factor services to firms in the form of labour, enterprise and
capital. In turn, firms provide factor services to implement the investment
Leakages impact on the total flow of funds in the circular flow of income
Taxation on the inputs into the new infrastructure project is a leakage from
households and firms to the government
Other leakages are spending on imports of materials to implement the new
infrastructure project
Household savings are a leakage from factor income
Equilibrium in the circular flow will depend on the balance between injections and
leakages.
Maximum level 2 for a one-sided response
AO3 Evaluation (max 4 marks)
The circular flow model is a simplified view of reality.
The impact will depend upon the net of injections and leakages.
There could be a negative impact on the circular flow of income if leakages
exceed injections.
Most forms of new infrastructure have a negative impact not taken into account by the
model
Consideration as to whether all new infrastructure always has a positive impact on the
circular flow of income
A one-sided response cannot gain any marks for evaluation.
AS MACRO 5
