Circular Flow of Income [ Biz/ed Virtual Developing Country ]

The Virtual Developing Country is a case study of Zambia. There are a series of field trips available looking at different issues connected with economic development. This trip is the Copper Tour and this page looks at the Circular Flow of Income.


The National Income Accounts: Measuring the Circular Flow of Income:

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The circular flow of income is a simple model of the economy showing flows of goods and services and factors of production between firms and households. In the absence of government and international trade this simple model shows that households provide the factors of production for firms who produce goods and services. In return the factors of production receive factor payments, such as wages, which in turn are spent on the output of firms. This basic flow is shown in the diagram below.

Circular flow of income

In reality the households do not spend all their current income. Some is saved. This represents a leakage from the circular flow. In addition to the consumer spending, firms also carry out investment spending. This is an injection to the circular flow of income, as it does not originate from consumers' current income.

In the real world the government and international trade sectors must also be included. Economic systems are in reality three sector open economies. Consequently there will be additional leakages and injections. Government spending will be injected into the circular flow and taxation will leak from it. Export flows will be injected and imports flows leaked. A full circular flow with leakages and injections is shown below.

Circular flow of income

This model of the economy demonstrates that economic activity is a flow. In actual fact it can be considered two flows, one of goods and services and a flow of money. The size of these flows is an indicator of the amount of economic activity. The circular nature of the flows means that there will be a number of different ways of measuring the size of the flow. Economists maintain that there are three possible ways of measuring this flow with each way looking at a different part of the circular flow of income. However all should give the same answer:

  • The output method: the total amount of goods and service produced in one year
  • The expenditure method: the total amount of domestic spending by consumers, firms, government and foreigners
  • The income method: the total incomes earned by the factors of production involved in the production of goods and services in one year

National income accounting is the process whereby countries attempt to measure these flows. The result of each the three methods is the gross domestic product. An examination of the national income accounts gives an insight into the economy.

It provides data which governments and external agencies can use in a variety of different ways. These include:

  • to determine the extent of economic growth
  • to measure changes in living standards over time
  • to make comparisons of economic performance and living standards between countries
  • to examine and judge the performance of different sectors of the economy

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Related Glossary Items:
Factors of Production

Related Theories:
The Causes of Economic Growth
Composite Indicators of Poverty and Living Standards