Circular Flow

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1. Explain the functioning of the Circular Flow of Income.

The Circular Flow of Income is a model that indicates how money moves throughout an economy. This model was mainly in use up to the Second World War and is a model developed by classical (monetarist) economists. Many models have been developed based on The Circular Flow of Income.

The Circular Flow of Income consists of two parts, the inner circular flow and injections and withdrawals. In the inner circular flow there are two basic economic institutions, these are firms and households and these have an economic interaction. The following diagram shows the inner circular flow of income:

The model shows that firms pay money to households in the form of factor payments. In other words, they pay households wages, dividends on shares, interest and rent in return for labour, capital and land. They do this in order to maintain their production. Households then use this income to pay firms for the consumption of domestically produced goods and services (Cd) thus completing the circular flow. If households spend all of the income they receive on Cd and firms in turn spend all of their income on factors of production then the flow will just continue indefinitely.

However, in the real world households will only use a proportion of their income for Cd. Some of households’ money is withdrawn from the economy as households save money for the future, lose part of their earnings in taxation, and in an open economy they spend money on imports. Furthermore, only part of the income firms receive is from Cd, there is also income for firms from outside of the inner flow as governments spend on public goods, banks make loans to firms and individuals for investment, and some domestic goods are exported abroad. Here is the model including injections and withdrawals.

There are three types of withdrawals from the inner flow. Households will save a proportion of their income in banks and building societies, households will have to pay taxes to local and national government and households also spend some of their income on imports from abroad. To balance these withdrawals out there are injections back into the economy; financial institutions use savings they collect to invest as they offer additional loans to firms, the government collects taxation and redistributes the revenue in the form of government spending on education, healthcare, military and infrastructure, and there is a demand for domestic goods and services from foreign countries, so firms get income from exports. At a state of equilibrium in the Circular Flow of Income Injections are equal to Withdrawals. If the Circular Flow of Income is in a state of disequilibrium it is corrected over time within the model, therefore there is no need for any government intervention in the Circular Flow of Income.

2. Explain how equilibrium is restored in the Circular Flow of Income when: (i) Injections (J) are higher than Withdrawals (W), J > W (ii) Injections (J) are lower than Withdrawals (W), J < W

i)

If J > W more money is being injected into the inner circular flow of income than is being withdrawn. Injections are made up of government expenditure, investment and the sale of domestically produced goods as exports. Higher government spending, higher investment and higher exports would mean that aggregate demand would increase. This implies that households are wealthier and therefore will consume more as they have increased disposable income, causing a further increase in aggregate demand. Firms will observe that due to an increase in sales demand is rising. Firms must then take time to make a decision on whether they need to increase production to meet this rise in demand, or, if their good is durable there may be unsold stock (possibly from a previous...
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