The Circular Flow of Income (AQA A Level Economics)

• 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 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

The circular flow of income between households and firms 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

• 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

An open economy is one that trades with the world. North Korea is a closed 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

• 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