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The Circular Flow

Above is a 2 sector model of the circular flow. In the model are households and firms with the firms producing goods and services by hiring labour and other factor inputs from households. Households supply their labour and buy consumer goods. In return for supplying factor inputs, households receive income which they spend on consumer goods.

This is a closed system and so the flows must balance. This shows the 3 methods of how GDP can be measured, by incomes, by total amount of output, or by total expenditure.

In reality there are leakages (or withdrawals) from the circular flow so in practise it isn’t a closed system. These leakages are savings, tax and imports. If money is saved (not economic investment) then it doesn’t contribute to AD. If the government takes money away from the economy or doesn’t spend it, or similarly if there are more imports than exports then the economy will slow down. These 3 leakages determine the size of the multiplier.

There are also 3 injections into the circular flow. These are investment, government spending and exports.

(T)=Tax, (S) = Savings, (M) = Imports, (G) = Government Spending, (I) = Investment, (X) = Exports