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The Circular Flow of Income
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The Circular Flow of IncomeIn the diagram, the economy is divided into two major groups: firms and households. Each
group has two roles. Firms are producers of goods and services; they are also the employers
of labour and other factors of production. Households (individuals) are the consumers of
goods and services; they are also the suppliers of labour and various other factors of
production.
Note that money is a stock concept, and income as well as expenditure are flow concepts.
The relationship between money and income depends on how rapidly the money circulates
(its velocity of circulation). For instance, if there is £500 billion of money in the economy
and each £1 on average is paid out as income three times each year. Then the national annual
income will be 1.5 trillion.
The inner flow, withdrawals (leakages) and injections
The inner flow
Firms pay money to households in the form of wages and salaries, dividends on shares,
interest, and rent. These payments are in return for the services of the factors of production
that are supplied by households (e.g. labour, land, capital). Thus on the left-hand side of the
diagram money flows directly from firms to households as factor payments.
Households pay money to domestic firms when they consume domestically produced goods
and services. This is shown on the right-hand side of the inner flow. There is thus a circular
flow of payments from firms to households to firms and so on.
If households spend all their incomes on buying domestic goods and services, and if firms
pay out all this income they receive as factor payments to domestic households, and if the
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