Modelling the Economy (SL IB Economics)

• The circular flow of income is an economic model that illustrates the money flows in an economy
  • There is a simple model which shows the money flows between households and firms
  • There is a more complex model which adds in other economic agents including the government, financial sector and foreign trade (net exports)
    
    

A diagram showing the simplified Circular Flow of Income between households and firms

 

Diagram Analysis

• Households own the wealth in the economy
  • These are the factors of production
• Households supply their factors of production to firms and receive income as a reward
  • They receive rent for land, wages for labour, interest for capital, and profit for enterprise
  • With this income, they purchase goods/services from firms
• Firms purchase factors of production from households
  • • They use these resources to produce goods/services
    • They sell the goods/services to households and receive sales revenue
       

• Money can enter or leave the circular flow of income in an economy
  
  
• Injections add money into the circular flow of income and increase its size
  • Increased government spending (G)
  • Increased investment (I)
  • Increased exports (X)
    
    
• Leakages (withdrawals) remove money from the circular flow of income and reduce its size
  • Increased savings by households (S)
  • Increased taxation by the government (T)
  • Increased import purchases (M)
     
• There are high levels of interdependence between households, firms, the government, the financial sector, and the foreign sector (foreign firms and households)
    

A diagram that shows the injections and leakages that influence the relative size of the circular flow of income

Diagram Analysis

• Government: Government spending (G) is an injection and taxation (T) is a leakage
• Financial sector: Investment (I) is an injection and savings (S) is a leakage
• Foreign sector: Exports (X) is an injection and imports (M) is a leakage
   
• The relative size of the injections and withdrawals impacts the size of the economy:
  • Injections > withdrawals = economic growth
  • Withdrawals > injections = fall in real GDP
• Injections represent new income in the economy
• Changes to any of the factors that influence government spending, investment, consumption and net exports will increase/decrease the relative size of the circular flow of income
  • E.g. An increase in interest rates will increase savings (withdrawal), and reduce consumption and investment