Circular Flow of Income Lecture Notes

Introduction

• Circular Flow of Income: A model to understand the economy.
• Two Key Conclusions:
  1. Examines economic growth.
  2. Measures economic growth (GDP).

Simple Economic Model

• Economic Agents:
  • Households: Provide factors of production (land, labor, capital, enterprise).
  • Firms/Businesses: Utilize these factors to produce goods and services.
• Factor Incomes:
  • Reward for land: Rent
  • Reward for labor: Wages and salaries
  • Reward for capital: Interest
  • Reward for entrepreneurship: Profit
• Spending: Households spend their incomes on goods/services produced by firms.

Circular Flow Model

• Simplified Model: Movement of spending and income.
• Limitations: Excludes government and international sectors.

Expanded Model

• Income Uses:
  • Not all income is spent; could be saved (S), taxed (T), or spent on imports (M).
  • Leakages/Withdrawals: Income not spent on domestic goods/services.
• Expenditure Sources:
  • Beyond households; firms (investment - I), government (G), and exports (X) contribute.
  • Injections: Investment, government spending, and exports add money to the economy.
• Full Sector Circular Flow: Includes government and international sector.

Economic Growth and GDP

• Injections vs. Leakages:
  • If injections > leakages: Economic growth increases.
  • If injections < leakages: Economic growth decreases.
  • If injections = leakages: Macroeconomic equilibrium (steady economic growth).
• GDP Measurement Methods:
  1. Output Method: Final value of all goods/services produced annually.
  2. Income Method: Sum of all factor incomes annually.
  3. Expenditure Method: Total expenditure (C + I + G + (X-M)).
  • All methods yield the same GDP figure as they measure the same circular flow.

Conclusion

• Transaction Example:
  • Spending on a good (e.g., cricket bat) = Value of output = Income to seller.
  • Spending = Output = Income in any transaction.
• Model Utility: Provides insight into economic growth and precise GDP measurement.

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Note: Output = Income = Expenditure, ensuring consistency across measurement methods.