The Circular Flow of Income (AQA A Level Economics)

National Income

• National income is the total value of the new output of an economy over a period of time

  • The output is produced by the physical (machinery) and human capital in the economy 

• Income is a flow in the economy, whereas wealth is a stock of assets that can be used to generate income

• Nominal and real GDP are often used to measure national income

  • Nominal GDP is the actual value of all goods and services produced in an economy in a one-year period

    • There has been no adjustment to the amount based on the increase in general price levels (inflation)

    • The word nominal refers to the fact that the metric has not been adjusted for inflation

• Real GDP is the value of all goods and services produced in an economy in a one-year period, adjusted for inflation

  • E.g. If nominal GDP is £100bn and inflation is 10%, then real GDP is £90bn
     

Real national income is an indicator of economic performance 

• If real income is rising, then the economic performance of the country is improving

  • It is also very likely that the standard of living in the economy is also improving 

• If real income falls during a period of recession, it is likely that there will be a fall in the standard of living of individuals in the economy

• The rate of change of national income measures the change in economic growth in an economy 

• Both the level and rate of change in national income are valuable for cross-country comparisons

The Closed Circular Flow of Income Model

• The circular flow of income model is used to illustrate national income and the flow of money, resources and goods in an economy

  • There is a simple model which shows the money flows in a 'closed economy'

    • This shows 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)

Diagram: Circular flow in a Closed Economy

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 and services from firms

• Firms purchase factors of production from households

  • They use these resources to produce goods and services

  • They sell the goods and services to households and receive sales revenue

The Open Circular Flow of Income Model

• An open circular flow of income demonstrates the relationship between all of the economic agents that interact in a global world

• There are high levels of interdependence between households, firms, the government, the financial sector, and the foreign sector (foreign firms and households)

Diagram: Circular flow in an open Economy

Diagram analysis

• Households and firms have been explained in the closed circular flow of income model above

• Government: The government influences the size of the circular flow through its taxation (T) and spending policies (G)

• Financial sector: The financial sector influences the size of the circular flow by providing funds for Investment (I) and a safe place for households and firms to store their savings (S)

• Foreign sector: Globalisation means that the level of exports (X) and imports (M) significantly affects the size of the circular flow of income in most countries

Income = Output = Expenditure

• With reference to the circular flow of income model, national income can be calculated using three possible approaches  

1. The expenditure approach

   • This approach adds up the value of all the expenditures in the economy in a year and includes consumption (C), government spending (G), investment (I) by firms and net exports (X - M)

   • Nominal GDP = C + I + G + (X-M) 

2. The income approach

   • This approach adds up the payments (rewards) for the factors of production in a year and includes the wages from labour (W), rent from land (R), interest from capital (I) and profit from entrepreneurship (P)

   • National Income = W + R + I + P 

3. The output approach

   • This approach adds up the value of all finished goods/services produced within the economy each year (national output)  

• All approaches should provide the same figure

  • One agent's expenditure is another agent's income

  • The value of finished goods ready for sale is equal to the expenditure paid to acquire them

• The value of GDP is different to the volume of GDP

  • The value is the monetary worth

  • The volume is the physical number