The Circular Flow of Income

• The circular flow of income shows the movement of income, output, and expenditure throughout the economy.
• The key agents in the circular flow of income are households and firms.
• In a closed economy, income, output, and expenditure are equal.
• Injections (such as investment and government spending) and leakages (such as savings and taxation) affect the size of the circular flow of income.

The circular flow of income is a basic model that shows how income, output, and expenditure move throughout the economy. It involves households and firms, with consumer spending flowing from households to firms, and goods and services flowing from firms to households. Additionally, households provide labor to firms, and firms pay wages to households. In a closed economy with only households and firms, income, output, and expenditure flow continuously. The size of the economy can be measured by the income earned in producing goods and services, the value of the output produced, or the expenditure used in purchasing the output. Ideally, these measurements should be equal. However, injections and leakages complicate the model. Injections, such as investment and government spending, increase the circular flow of income, while leakages, such as savings and taxation, decrease it. International trade also affects the circular flow, with exports being an injection and imports being a leakage. The multiplier and accelerator effects are related to the circular flow of income. The multiplier refers to the process by which an injection into the circular flow leads to a greater increase in aggregate demand. This is because one person’s expenditure becomes another person’s income, creating a chain reaction of spending. The accelerator effect states that levels of investment depend on the rate of change of GDP, rather than its overall level. Rapid increases in GDP lead to increased investment, while decreases in GDP cause investment to decline. This intensifies the economic cycle, with booms and slumps.