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Circular Flow of Income and Equilibrium Level of National Income

Updated: Nov 11, 2018

Theme 5: Introduction of Macroeconomics

Topic: Circular Flow of Income and Equilibrium Level of National Income

Relevance: H1 and H2 Economics

Introduction

The equilibrium level of national income can be understood using the circular flow of income framework through the interactions between the different sectors of an economy. Equilibrium level of national income occurs when there is no tendency for the levels of national income (Y) to change.

An open economy consists 4 sectors, Household, Firms, Government and Foreign sector. However, the financial institution (banks) is taken into account to better understand the flow of money, however its role is only to help facilitate the flow of money between household and firms.


2 Sector Economy

Before we can learn about the 4 sector economy, let us first look at the basic 2 sector economy consisting of just Households and Firms.

Households and firms interact in the factor market where factors of productions are supplied and demanded as shown in Figure 1.

In the factor market, firms represent all consumers of factors of productions while households represent all producers of factors of productions.

Households and firms also interact in the product market where goods and services demanded and supplied as shown in Figure 2.

In the product market, households represent all consumers of goods and services while firms represent all producers of goods and services.


Factor Market

In order to produce goods and services, firms will hire factors of production (land, labour, capital and entrepreneurship) from households and in return pay households income in terms of rent, wages, interest and profits. The total income (Y) earned by household is also regarded as the national income for the economy.

Figure 1: Resource Markets

Product Market

Household using the income earned from the factor market will consume goods and services produced by firms. This expenditure by households is known as consumption expenditure (C) which becomes income for firms.

Figure 2: Product Markets

In summary, income flows between households and firms either as factor income (Y) or consumption expenditure (C) as shown by the green arrows in Figure 3.

Figure 3: Two Sector Economy

However, the financial institution such as banks should be taken into account to better understand the flow of money as they help facilitate the flow of money between household and firms. Household might not spend all their income and save in the banks instead, while firms can approach banks to borrow money to invest in the production of goods and services as shown in Figure 4.


Figure 4: 4 Sector Economy

4 Sector Economy

In a 4 sector economy, also known as an open economy, we need to consider the actions of Government and Foreign sector.


All government collect taxes (T), both direct and indirect, which will be deducted from households’ income earned. With the tax revenue collected, government can also consume goods and services produced by firms, this is known as government expenditure (G). This could be in terms of infrastructure building, healthcare and education.


Also, households might be consuming goods and services produced abroad, and this expenditure will not be flowing to domestic firms but foreign firms in terms of import expenditure (M). Domestic firms might also sell goods and services produced abroad to foreign consumers which in return will earn exports revenue (X).


Leakage / Withdrawal (W)

As you can see from Figure 4, savings, taxes and import expenditure redirect the flow of money from firms and this can been seen as a form of leakage or withdrawal from the circular flow of income.


Injection (J)

On the other hand, investment, government expenditure and exports revenue, though might not come direct from household, but they are a source of income for firms and this can been seen as a form of injection into the circular flow of income.


Equilibrium Level of National Income


The equilibrium level of national income occurs when injections (J) into equals to withdrawals (W) from the circular flow of income. Which means the sum of savings, taxation and import spending (S + T + M) equal to investment, government spending and export revenue (I + G + X).


When J>W it means that the addition into the circular flow through I, G and X is more than the withdrawals from the circular flow from S, T and M. This causes the circular flow of income to increase. As households receive more Y, some goes to C, S, T and M and they each increase. As C increases, Firms enjoy a higher Y, and pay resource owners for factor inputs again. This process continues through multiple rounds, increasing C, S, T and M and hence withdrawals since W = S+T+M, until W=J. An economy will grow if the value of injections is greater than the value of withdrawals


When J<W, there is a larger withdrawal from the circular flow of income than the addition through I, G and X, thus equilibrium Y falls. The fall in Y causes households to have less to spend on C, S, T and M, similarly, these components, and W keep falling through multiple rounds until W=J when equilibrium Y is reached. An economy will shrink if the value of withdrawals is greater than injections.


Conclusion

Therefore, all of the components of the circular flow of income will determine the equilibrium level of national income in such an economy.

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