LEARNING OBJECTIVES
After you have read this section, you should be able to answer the following questions:
- What is the circular flow of income?
- What is the national income identity?
Looking at some basic measurements of the economy has allowed you to be more concrete about the problems in Argentina. You report back to the International Monetary Fund (IMF) team that production has been declining in recent years. You also report that there was a recent increase in the price level. As yet, though, you do not know anything about either the causes or the consequences of these events. Measurement of the economy tells you what has happened, but it tells you neither why it happened nor what it means. Measurement is not enough. We need frameworks to help us make sense of the data that we gather.
Economists use many different kinds of frameworks to make sense of an economy. One of the most important is called the circular flow of income. To understand the circular flow, recall our working definition of economic activity: “goods and services produced for sale.” So far, we have focused on production. Now we think about the “for sale” part.
Toolkit: Section 16.16 "The Circular Flow of Income"
As individuals and firms buy and sell goods and services, money flows among the different sectors of the economy. The circular flow of income describes these flows of dollars. From a simple version of the circular flow, we learn that, as a matter of accounting,
gross domestic product (GDP) = income = production = spending.
This relationship lies at the heart of macroeconomic analysis.
There are two sides to every transaction. When you purchase a piece of computer software, you give money to the seller, and the seller gives the software to you. (You might literally hand over dollar bills and receive a CD, or you might enter a credit card number into a website entitling you to a download. The idea is the same either way.) There is a flow of money from you to the seller and a flow of goods or services from the seller to you. This is true for all transactions: as individuals and firms buy and sell goods and services, money flows among the different sectors of the economy. Macroeconomists follow the money. By tracking these flows, we can understand the links between different markets; by understanding these links, we gain insight into the functioning of an economy.
One linkage is between income and spending. The spending by households on goods and services is funded by the income that households earn. But this income comes from firms, and they get their income from the spending of households. Thus there is a circular flow of income in an economy as a whole.
Household income comes from two main sources: (1) Households contain workers who sell their time to firms and receive wages in return. (2) Households are the ultimate owners of the firms—shareholders live in houses too—and thus any profits that firms make are returned to households. All firms in an economy are owned by someone, and any profits they make do not vanish into thin air but must eventually show up as someone’s income.
Households take this income and do one of two things: they either spend it or save it. To start, let us figure out what would happen if no household income is saved. Households spend all their income, and this money becomes the revenue of firms. Firms send these revenues back to households, either as labor income or profits, and so the circular flow continues.
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