Circular Flow

CIRCULAR FLOW OF INCOME The Circular Flow of Income, expenditure and output is a model of the economy which shows the movement of goods and services between households and firms and their corresponding payments in money terms
Money circulates from households to firms and back again. The more a households spend and the more firms produce, the higher the levels of income. Income + output in economy should always be same and are measured by GDP.
Circular Flow emphasizes importance of interactions of households, firms + other economic factors in macro-economy
Households own all FoP (LLCE) Firms are producing units which hire services provided by the people from households
Money moves from households to firms when they buy goods + services and money moves back to households as payment for using the factors of production through rent (land) , wages (labour), interest and profit/dividend (capital).

Leakages – (withdrawals) from circular flow income are S (savings), T (tax) and M (imports). Some income is saved and saving represents leakage from the circular flow of income because its part of the income paid out by firms which does not return to them through spending of households. If you save, economy slows down as there's less money in circular flow. So if Gov. takes money from economy in form of tax and doesn't spend it, or if people buy more things from abroad than they export (foreign trade), economy slows down as money leaves circular flow. Leakages determine size of multiplier. Tax is leakage because they remove purchasing power from the system.

Injection – in circular flow are I (investment – increase in capital stock), G (government spending) and X (exports) Export is injection as spending of foreign households on domestic produced output is an additional source of income.
Increase in investment (machinery, building) may increase spending in an economy as well as productive capacity enabling economic growth. Firms contribute to expenditure when they buy investment goods and add to their productive capacity. Change in balance between investment + consumption activity has effect on LR path of economy. Government spends (inj) on G/S – provisioning public goods but to finance these they must raise revenue – tax (w/d)
International Trade is important as part of expenditure on G/S is form of exports and part is by households on imports
Injections increase circular flow and a change in any of these are magnified by multiplier.

If injections > leakages, spending on goods and services will exceed planned level of production. Firms will expand output and national income will rise (economy grows). If leakages > injections, production will exceed the current level of expenditure. Firms therefore reduce output and national income will fall (economy contracts)

Injections = leakages, national income won't change → National Income Equilibrium: where AD for G/S = AS produced

Wealth effects: Wealth is sum of all assets in an economy. It is a stock concept whereas income is a flow concept. This means wealth doesnt have direct impact on circular flow of income but changes in wealth can effect income/ spending
If you live in a property that increase in value, you may feel more confident about spending in the economy and your increased spending will then become part of circular flow of income. If houses become more expensive, one can go to their mortgage provider and request mortgage equity – taking loan based on increased wealth. When that loan is spend, circular flow increases. In contract, when capital markets take a downturn in USA, people living on pensions in UK might find that their incomes fall because dividends on pension funds are often based on capital gains of shares.
In UK most wealth is held in form of housing (59%) in other major forms of wealth are stocks, shares, and capital assets

Exam skills: Income is measured by real GDP. Wealth is stock concept. income is flow concept. Wealth in UK is 6.5 trillion – 5x total income in economy. Most income in UK is help in form of housing (59%) Capital assets/stock in UK is about 2.6 trillion – less than cost of maintaining all capital stock in current condition – cost known as depreciation. Consumption is not an injection. You cant argue that increase in house price (wealth) causes fall in AD because people dont have as much money to spend on other things.

A mid market taxi firm. Scenario is a recession
In a recession, or downturn in the economy, consumer confidence decreases because spending power has reduced. This wall cause those taxi users to switch to cheaper forms of transport e.g. public transport (buses) or trains.
London already has a transport system of underground trains and buses so those middle class incomers may choose to switch to this. However there may be some users who have no other choice than to use a taxi so they have to pay extra
Solution is to decrease prices in order to keep demand sustained so taxi users remain using taxis and not overcrowd the other forms of transport.
Consumer behavior