The circular flow of income and spending shows connections between different sectors of an economy.
It shows flows of goods and services and factors of production between firms and households
The circular flow shows how national income or Gross Domestic Product is calculated
Businesses produce goods and services and in the process of doing so, incomes are generated for factors of production (land, labour, capital and enterprise) – for example wages and salaries going to people in work.
Leakages (withdrawals) from the circular flow
Not all income will flow from households to businesses directly. The circular flow shows that some part of household income will be:
- Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit
- Paid to the government in taxation (T) e.g. income tax and national insurance
- Spent on foreign-made goods and services, i.e. imports (M) which flow into the economy
Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of production (output)
Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.
Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology
The government, i.e. government expenditure (G) e.g. on the NHS or defence
Overseas consumers buying UK goods and service, i.e. UK export expenditure (X)
An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow.
National income refers to the aggregate, or total, income of the nation which results from economic activity. Income, however, depends upon how much output is produced and as output is a continuous process rather than a stock, we have to increase this output over a specified time period, usually one year. Total output is referred to as national product, and includes all the goods and services produced each year.
National income was defined by Alfred Marshall as “the aggregate net product of and sole sources of payment to all agents of production.”
If we study this definition closely, we can identify three components:
- Aggregate net product, i.e., total output
- Sole source of payment, i.e., incomes
- All the agents of production, i.e., how the national product is distributed and, therefore, the source of all expenditure.
From this definition, we can identify three possible methods of measurement: output, income and expenditure.
Measurement by either of these methods will produce identical results because theoretically:
National income = national output = national expenditure
In this context, we refer to circular flow of income which refers to the flow of payments and receipts between domestic firms and domestic households. Money passes from households to firms in return for goods and services produced by firms and money passes from firms to households in return for the factor services provided by households. The simple notion that the money value of the income of households must equal the money value of household’s expenditure to purchase this output provides the basis for national income accounting.
In order to understand the concept of income as a flow it is useful to study the circular flow of income in the form of a flow diagram. If Fig. 3 is studied closely, it can be seen that households supply productive services (factors of production like land, labour, capital and entrepreneurial talent) to firms and in return receive the factor rewards in the form of wages, rent, interest and profit.
These are the total of all incomes to households and will therefore form the basis of all expenditures. When expenditures are made with firms in the form of consumption then there must be an equivalent flow of goods and services from firms to households. It is, therefore, possible to measure each of these flows (of output income and expenditure) and achieve the same result.
Hence, the conclusion: national income = national output = national expenditure. In reality, the circular flow diagram, portrayed in Fig. 3 needs to be slightly modified. For example, much of national expenditure is in the form of investment expenditure between firms. However, it does not illustrate the concept of national income as a flow.