Modelling the Economy (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
The Circular Flow of Income
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
Leakages & Injections
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
Examiner Tips and Tricks
Remember to consider the net effect and proportionality of the injections and withdrawals. For example, if the size of the government spending is large, it is likely to completely outweigh the combined withdrawals of savings and imports.
This model connects extremely well to the concept of interdependence. There are high levels of interdependence between households, firms, the government, the financial sector, and the foreign sector (foreign firms and households).
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