2.4.1 - National income

The Basic Circular Flow

Start with the simplest version of the economy: a closed economy with no government and no foreign trade. In this two-sector model, there are only households and firms. Households spend all of their income, and firms pay out all of their revenue as incomes, so nothing leaks out of the flow.

Households own the factors of production. They supply land, labour, capital, and enterprise to firms. In return, firms pay households rent for land, wages for labour, interest for capital, and profit for enterprise. Households then spend that income on the goods and services firms produce, so the flow continues. For example, a baker supplies her labour to a bakery and is paid wages; she spends those wages in shops, and that spending becomes revenue for firms, which pay it out again as incomes.

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The diagram groups the flows by direction. The left arc lists what moves from firms to households: goods and services, and the factor payments rent, wages, and interest (profit, the reward for enterprise, is paid the same way). The right arc lists what moves from households to firms: factors of production and consumer expenditure. Inside these arcs are two different flows. The real flow is the movement of factors of production to firms and goods and services back to households. The money flow is the movement of income payments to households and expenditure back to firms. In every exchange, the money moves in the opposite direction to what it pays for: labour goes to firms while wages go to households, and goods go to households while spending goes to firms. Keeping those two flows separate is important because students often describe money moving when the question is really asking about resources, or vice versa.

Measuring National Income

The circular flow model also shows why economists can measure economic activity in three equivalent ways.

In the simple model, the same activity can be seen from three angles:

These are identical by definition in the simple circular flow:

Every pound spent on output becomes revenue to firms, and that revenue is then paid out as incomes to households. Whatever is left after paying wages, rent, and interest is profit, which is itself income for the firm's owners, so all of the revenue ends up as someone's income. If firms produce and sell GBP1 million of output, there is GBP1 million of expenditure and GBP1 million of income somewhere in the economy. That is why economists can move between output, expenditure, and income measures when calculating national income.

Injections, Withdrawals, and Equilibrium

The two-sector model is useful, but it is too simple to describe a real economy. Once we add the financial sector, government, and the foreign sector, some money enters the circular flow from outside normal household spending and some money leaves before it returns to domestic firms.

The three injections are investment, government spending, and exports. Investment means firms buying capital goods or adding to inventories. Government spending means public expenditure on things such as services and infrastructure. Exports are spending by foreign consumers or firms on goods and services produced domestically.

The three withdrawals are saving, taxation, and imports. Saving is income not spent on current consumption. Taxation removes income from households and firms until the government re-spends it. Imports are spending on foreign-produced goods and services, so the money leaves the domestic flow. For example, if UK households buy Samsung phones produced abroad, that spending counts as an import and a withdrawal from the UK circular flow. By contrast, spending by overseas visitors on hotel rooms in London counts as an export of services and an injection into the UK flow.