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Circular Flow of Income Model

Economics (Year 11) - Introduction to Macroeconomics

Carys Brown

What is the Circular Flow of Income Model?

The Circular Flow of Income Model describes the flow of resources, goods and services and income in parts of the economy. It divides the economy in to sectors.

  • The Factor Market: The factor market is shown in orange. This demonstrates the flow of the Factors of Production (land, labour, capital) from households, in return for income from firms.

  • The Product Market: The Product Market is shown in blue as it represents how firms/producers supply goods and services to households/consumers in return for their spending.

The Financial Sector

The Financial Sector, shows how Savings represent a leakage from the circular flow as it reduces the amount of money Consumers are spending in the economy. Investment money is then injected by firms into the economy as they invest in better technology, machinery or more factory space, in turn, allowing a greater production of Goods and Services (increases flow of income).

The Government Sector

The Government Sector, shows that Taxes are a leakage. This is money out of the pockets of consumers and given to the government. However, Government Spending is an injection, as they invest in infrastructure and projects in order to create more jobs (increasing the flow of income.)

The Overseas Sector

The Overseas Sector, shows that imports are a leakage because the money Australian’s spend on goods from foreign countries, contributes to their economy and GDP. However, Exports are injections because means Australia makes a profit from the spending from other nations (increasing the flow of income.)

Buzz Words and Up-to-Date Statistics

The model shows the interdependence between different sectors. For example, a rise in taxes would reduce the amount of money that people have to spend = reduced production and a fall in income. Australia’s “Marginal Propensity to Consume” (MPC) is 65%. This means that Australian’s spend 65% of their income and save 35%. This figure is higher during periods of high confidence and low during periods of low confidence.

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