The Circular Flow
Definition
Circular flow of income: the continuous movement of income and spending between households, firms, the government and the international economy.
Households and Firms
- Households own the factors of production (land, labour, capital and enterprise) and supply them to firms.
- Firms pay factor incomes in return, such as £2,000 a month in wages, plus rent, interest and profit.
- That income becomes household spending on the goods and services firms produce.
- The spending returns to firms as sales revenue, which funds the next round of factor payments, so the loop is self-renewing.
Key Idea
- The real flow of factors and goods runs one way; the money flow of incomes and spending runs the opposite way.
- One agent's spending is always another agent's income, which is why the flow is continuous.
A Closed Economy
Definition
Closed economy: an economy with no international trade, so it has no exports or imports.
- A closed economy contains three sectors: households, firms and the government.
- The government withdraws income as taxation (T): e.g. £400 of tax on a £2,000 wage cuts the income households can pass on as spending.
- The government returns income as government spending (G) on schools, roads and healthcare, adding to firms' revenue.
- Cause → effect: if G > T the flow of income expands; if T > G it contracts, because more income is withdrawn than returned.
An Open Economy
Definition
Open economy: an economy that trades with the rest of the world, so it has both exports and imports.
- An open economy adds a fourth sector, the international economy, linked to domestic firms and households through trade.
- Exports (X) add income: e.g. an overseas buyer pays £5,000 for domestically made machinery, so foreign spending enters the domestic flow.
- Imports (M) remove income: e.g. £300 of household spending on imported electronics leaves the domestic flow and becomes income abroad.
- It depends on net exports: if X > M income is added to the flow on balance, but if M > X income leaks out.
Example
- A household receives £2,000 in wages and faces a tax rate of 20%.
- It pays 20% × £2,000 = £400 in tax and saves £200, leaving £1,400 to spend.
- Of that £1,400, £300 buys imports and leaves the flow, while £1,100 is spent with domestic firms and returns to them as revenue.
- The £1,100 becomes other households' income next round, while the £400 + £200 + £300 = £900 withdrawn only re-enters if firms invest, the government spends and foreigners buy exports.
Exam technique
- Build the model in stages: households and firms first, then add the government, then the international economy.
- State whether the economy is closed or open before you describe the flows.
Common Mistake
- A closed economy still has a government, so do not treat 'closed' as households and firms only.
- Only an open economy includes trade, so exports and imports belong there, not in a closed economy.
Self review
- Define the circular flow of income.
- Which three sectors appear in a closed economy?
- How do exports and imports change the flow in an open economy?
- Why is one agent's spending always another agent's income?
