Circular flow of national income

Introduction

This lesson starts the macroeconomics course. I have started this section of the course with the circular flow diagram which is an explanation of how a simple economy works. Your classes need to understand that a circular flow is an organic object with the factors of production and businesses supporting each other. Start by having your classes watch the video and then draw a simple economy diagram. The page also contains a fun activity based on the popular television series, lost. You could even start the lesson with this activity as a way of introducing the concept.

Enquiry question

What is the circular flow of income diagram and how does it illustrate the workings of a modern economy?

Lesson time: 90 minutes

Lesson objectives:

Explain, using a diagram, the circular flow of income between households and firms in a closed economy with no government.

Identify the four factors of production and their respective payments (rent, wages, interest and profit) and explain that these constitute the income flow in the model.

Teacher notes:

1. Beginning activity - begin with the opening activity and allow 15 minutes for your classes to complete this. (15 minutes)

2. Processes - technical Vocabulary - the students can learn the key concepts through the notes, which should take 10 minutes to go through and discuss.

3. Practise activities - included on the handout should take around 30 minutes. These are short answer exercises, some theoretical while activity 4 relates the circular flow diagram to the worlds leading economies.

4. TOK exercise - activity 5 asks your classes to consider whether or not we (as consumers) are slaves or beneficiaries of the capitalist model?

5. Reflection exercise - contains a relevant section A, paper one style question on this topic that your students can look at and discuss. This topic of course can be included on papers one and three of the examination and this page contains both types of questions to practise on. This activity could also be set as a homework or classwork exercise. (10 minutes)

6. Island activity - this fun activity based on the popular television series, lost will have your classes relate the concepts learnt in the lesson to an island activity. You could even start the lesson with this activity as a way of introducing the concept. (20 minutes)

Beginning activity

A game to introduce the circular flow of income

Make a set of placards - print each one on a piece of A4, so it can be seen from across the room. Labels needed: households; firms; government; imports; savings; taxation; exports; investment; Government spending

Give person A the household placard. Give person B the firms placard. Make A and B stand a couple of metres apart, ideally in the middle of the room.

Ask the class how A and B affect each other. Get them to describe flows of goods/services and factors of production, then get them to think about the corresponding flows of money. Represent each money flow with a piece of string held by A and B.

Get the class to predict what will happen if A saves - get person C to hold the savings placard and to take some of the "expenditure" string from A: what has happened to the length of string now going between A and B? i.e. what has happened to the size of the circular flow of income?

As you give out the placards, get the class to predict how each one will impact on the whole economy.

Key terms:

Circular flow of income - a diagrammatic illustration of a simple economy diagram.

Two sector model - a simplified form of the circular flow diagram, presuming no international trade or government intervention.

Four sector model - a more complex form of the circular flow diagram, containing leakages and withdrawals in the model.

Leakages from the circular flow - leakages out of the economy from savings, taxes, and imports.

Injections into the circular flow - injections into the economy from investment, government purchases, and exports.

Transfer payments - government redistribution of income and wealth (payment) made without any transfer of goods or services in exchange. Examples of transfer payments include welfare benefits as well as retirement payments. Transfer payments are not counted as part of injections into the circular flow because transfer they do not add to the overall output of the economy.

The activities on this page are available as a PDF file at: circular flow of income

Activities

1. Drawing a circular flow of income diagram

The following video explains the workings of the circular flow diagram. After watching the 5 minute video complete the activity that follows:

(a) What is the difference between a closed economy and an open economy?

A closed economy makes no provision for trade with other nations where as the open circular flow model includes exports and imports as injections and withdrawals into and out of the circular flow.

(b) How would the circular flow diagram of a mixed economy differ from the circular flow diagram present in a planned economy and a free market economy?

In a mixed economy there would be significant injections into the circular flow in the form of government spending and therefore significant withdrawals in the form of government taxes. In a free market economy both be much smaller.

In a planned economy there is no private sector so both the resource and the product market would be owned and controlled by the government.

Activity 2: Drawing a circular flow of income diagram

Start with two boxes, one you can label firms and the other households. Of course in this case households refers to any family unit from a single person living on their own to a large extended family. Draw labels to indicate the flow of goods and services and factor rewards from businesses to individual households and then arrows indicating factors of production and consumption from the families to individual firms. On opposite sides of the two boxes draw two additional boxes to indicate factor and product markets. Lastly, draw arrows to indicate leakages and withdrawals into and out of the circular flow.

Activity 3: The product and resource market

Start by watching the following short video before answering the questions which follow.

(a) Business sell goods and services in the ___________ market.

product

(b) Businesses purchase goods and services in the ____________ market.

resource

land, labour, capital and entrepreneurship.

(d) The four factor rewards are ___________________

Land - rent

Labour - wages

Capital - interest

Entrepreneurship - profit.

(e) Does your school operate in the product market or the resource market?

Both they sell a service in the product market and purchase desks, books e.t.c. in this market

They also purchase labour in the resource market.

(f) What is the role of tax in the circular flow diagram?

Governments provide public services as well as transfer payments, which feed into the circular flow. The funds required to pay for those services comes from taxation.

(g) Explain the role of the financial sector in the circular flow

A simple circular flow diagram illustrates households providing their factors of production to businesses and receiving factor rewards in return. In reality households will spend only a proportion of their rewards received and also save a proportion of it. The savings end up in banks and in return the financial institutions then recycle the savings in the form of investment revenue.

(h) Explain the role of international trade in the circular flow diagram.

Some of the goods and services produced by businesses are sold overseas in export markets increasing the size of the circular flow. Similarly households and businesses purchase goods and services from overseas (imports). If the level of exports > imports then the size of the circular flow grows. If the level of exports < imports then the circular flow shrinks.

Activity 4: Leakages and withdrawals from the circular flow

Consider the following data related to a range of countries in 2017:

Country	Tax revenue collected B $	Government spending B $	Budget deficit / surplus	Imports B $	Exports B $	Trade balance	Injections - leakages
USA	6,028	6,807	(779)	2,352	1,576	(776)	3
China	3,312	3,787	(475)	1,731	2,157	426	901
Japan	1,678	1,573	105	626	683	57	(48)
Germany	1,598	1,412	186	1,104	1,401	297	(111)
France	1,334	1,412	(78)	624	523	(101)	(23)
Italy	885	928	(43)	427	499	72	115
Turkey	174	190	(16)	197	157	(40)	(24)

Answer the following questions:

(a) Complete the following table above?

(b) Outline the implications for those nations with a combined budget and trade deficits.

While we cannot answer this definitively, without additional information about investment and savings levels in the economy, based on the information included in the table a number of the nations are running budget deficits, which is in part compensates for a deficit in net trade.

From the above list of nations China, Germany, Japan and Italy have a positive trade balance, meaning that the others - USA, France and Turkey will experience greater leakages from the circular flow, in the form of imports, than injections into the economy from export revenues. Without government intervention in the form of a budget deficit, this will act as a drag on the economies of those nations. That said a manageable budget and / or trade deficit is not a significant problem - at least in the short term.

Activity 5: TOK question

To what extent are we both slaves and beneficiaries of the capitalist consumer model?

More reading on this question can be accessed at: Freemans perspective

Hint:

This response depends entirely on your own political perspective. On a daily basis we are literally bombarded with adverts pushing products, many of which we do not need. Without our willing cooperation in this system the economy and the capitalism system could not survive.

But would life really be better off without capitalism? - this is less certain. During the 'cold war', the East German government was forced to build a wall to prevent its citizens from fleeing to the West so perhaps capitalism, for all its faults is not so terrible after all?

Activity 6: Link to the assessment

Example of a part (a) paper one question on this topic:

Explain how changes to the relative size of injections and leakages determine changes to the size of the circular flow of national income. [10 marks]

Command term: Explain

Key terms to define: injections, withdrawals, circular flow of national income

Responses should also include the following:

A diagram illustrating a circular flow diagram with both injections and leakages.

A recognition that when leakages from imports, savings and taxes are greater than injections into the circular flow from exports, investment and government spending, then the circular flow will reduce in size making the economy smaller.

Similarly, when injections into the circular flow are greater than leakages out of the economy then the circular flow will increase in size and the economy will expand.

The higher mark bands can be accessed by providing examples of situations where injections are greater than withdrawals or examples of the opposite situation. An example of situations where the circular flow is growing, might be when the government is looking to add stimulus to the economy by cutting taxes / interest rates and raising government spending levels.

Similarly, a situation when the size of the circular flow is shrinking might be when their government (or another government) is employing an austerity package and raising taxes as well as cutting back on public spending.

Activity 7: The scenario

On a flight to Los Angeles, your plane crashes and you find yourself as one of a small number of survivors on a remote and uncharted island, with little chance of rescue. It is up to your class to develop a new society, based on the resources available to you on this beautiful, tropical island.

You quickly decide on a plan of action and you start with the most basic economic question of all - what will be produced? How and by whom?

Equally importantly who will govern your island economy? Start by deciding on the following:

Land / distribution / location

will the land be privately owned? If so, who gets it and how?
should the land be owned by everyone together?
should you divide it up and distribute it?
if so, should it be divided equally? What constitutes equal?
who has rights to the water? How will these be provided for?

Labour

what work must be done?
list the kinds of jobs required to sustain the lifestyle you desire.
who should do these jobs?
what about the jobs that nobody likes?
does each person just have one job or many?
what happens with those survivors unable / unwilling to work

Land

what natural resources will be used to produce goods?
will there be rules governing use of natural resources? Why or why not? If yes, which?

Capital

What kind of capital (tools, machines, etc.) will be used to produce goods? How will this capital be attained?

Basic needs

Are there some basic needs that you believe should be guaranteed for everyone and if so, what are they? Or do you think that individuals should look after themselves?

Evaluation of your island economy

Demonstrate your understanding of economics by answering the following:

Evaluation of your island economy

Demonstrate your understanding of economics by answering the following:

1. Describe your group's:

a. economic goals

b. which goods and services will you produce and how?

c. which basic needs will be guaranteed for all citizens of the island.

d. who makes the economic decisions

2. Is your system more capitalist, socialist, or subsistence?

3. Explain the opportunity cost of pursuing any one of your goals.

4. Which problem did you have to address in your island economy? How did you respond?

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