Study Notes
Overview
The Circular Flow of Income is a foundational model in macroeconomics that illustrates the interdependence of the key economic agents: households and firms. For the OCR J205 specification, candidates are expected to master this model, not just as a diagram, but as an analytical tool. It shows how money moves through the economy, creating a continuous cycle of production, income, and expenditure. Understanding this flow is crucial for analysing macroeconomic performance, including changes in national income, employment, and economic growth. Examiners will award marks for a precise understanding of the distinction between real flows (the movement of actual goods and services) and monetary flows (the movement of money), and for the ability to analyse how the flow is affected by injections and withdrawals.
The Basic Two-Sector Model
At its simplest, the economy can be represented by two sectors: households and firms. These two groups are mutually dependent, and their interaction creates the circular flow.
1. Households:
- Role: Households are the owners of the four factors of production.
- Supply: They supply these factors to firms. For example, individuals provide their labour, landlords rent out property, savers lend their capital, and entrepreneurs risk their ideas and capital.
2. Firms:
- Role: Firms are the producers of goods and services.
- Action: They hire or buy the factors of production from households to produce goods and services.
This interaction creates two distinct but related flows:
- The Real Flow: This is the flow of physical things. Households provide factors of production (labour, land, capital, enterprise) to firms. In return, firms provide goods and services to households.
- The Monetary Flow: This is the flow of money. In return for the factors of production, firms pay households factor incomes (wages, rent, interest, profit). Households then use this income to purchase goods and services from firms, which is known as consumer expenditure.
Injections and Withdrawals
The basic model is a closed system, but the real economy is open. Money is constantly being added to (injected) and removed from (withdrawn) the circular flow. Credit is given for candidates who can accurately identify and explain these.
Withdrawals (or Leakages)
Withdrawals are parts of income that are not passed on as spending within the circular flow. There are three key withdrawals:
- Savings (S): Income that is not spent but saved in financial institutions (like banks). This money is withdrawn from the immediate flow of spending.
- Taxation (T): Income that is paid to the government. This includes income tax, corporation tax, and VAT. This money is not available for households or firms to spend.
- Imports (M): Spending on goods and services produced in other countries. The money flows out of the domestic economy to foreign firms.
Injections
Injections are additions of extra spending into the circular flow of income. There are three key injections:
- Investment (I): Spending by firms on capital goods (e.g., machinery, factories, technology). This spending is often financed by the savings in financial institutions.
- Government Spending (G): Spending by the government on goods and services (e.g., building schools, hospitals, infrastructure, paying public sector workers). This is financed by taxation.
- Exports (X): Spending by foreigners on domestically produced goods and services. This brings money into the economy from abroad.
Macroeconomic Equilibrium
The economy is said to be in a state of equilibrium when the rate of withdrawals is equal to the rate of injections.
Injections (J) = Withdrawals (W)
I + G + X = S + T + M
- If Injections > Withdrawals (J > W), the amount of spending in the economy exceeds the amount being leaked. This leads to an expansion of national output and income. The economy will grow.
- If Withdrawals > Injections (W > J), the amount being leaked from the economy exceeds the amount being injected. This leads to a contraction of national output and income. The economy will shrink.