Circular Flow of Income

What is the circular flow of income?

The circular flow of income or circular flow is a model of the economy in which the major exchanges between economic agents (households, corporates, banks, government) are represented as flows of money, goods and services.

Flow of products – goods and services

 

Households provide firms with labour (and financial capital through stock or corporate bond markets) factors of production (land labor capital enterprise).

Using labour and other factors of production such as land, physical capital and enterprise, firms generate output (goods and services). These goods and services are consumed by households and government, and other firms.

 

Flow of income

For employing the factors of production, firms pay rent to land owners/capital owners, and wages to workers. The excess over what is paid for factor payments is operating profit. Operating profit is taxed by the government. Profit after taxes are distributed to shareholders of the firm as dividends (some may be kept internally for future capital investment).

Using the wages or dividends they receive, households and shareholders of firms spend on goods and services produced by firms.

 

Note that this flow is similar for the government, just that the government does not seek to make profit, but to further socio-economic objectives i.e. higher standard of living for citizens.

The government receives tax revenue and spends it to achieve its objectives.

 

Flow of money

 

The banking sector is one of the underlying pillars in the economy. Banks receive deposits from housholds/firms/government and make loans to firms and consumers, earning a profit because the interest they charge on loans is higher than the interest they grant to depositors. Because banks are only required to keep a fraction of deposits (reserve requirement) and loan out the rest, they are able to “create money” through these loans, causing the growth in money supply (broad money) to be greater than the growth of the monetary base (narrow money).

 

In the new economy where households and corporations are more highly indebted than they were in the past, the change in credit supply (i.e. loan supply) can have a huge impact on the economy. Companies need short-term loans to manage their cash-flow, and long term loans for capital expenditure. Household need loans to buy houses, cars, university tuition and other big ticket items. In the most recent Global Financial Crisis, the banks almost became bankrupt due to their speculation in financial assets that caused massive losses – causing a contraction in credit supply that threatened the level of real economic activity through its impact on households and firms. Due to their critical importance in the process of money creation, governments all around the world were forced to step in to bailout the banks.
What is GDP (Gross Domestic Product)?

 

GDP (gross domestic product) refers to the total output of goods and services produced within a country’s borders. It is also equal to the national income or simply the income earned by the people in a country including foreigners and PRs.

 

What is GNP (Gross National Product)?

 

GNP refers to the total output of goods and services produced by the country’s citizens.

 

-by Quintessential Education

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