Circular Flow of Income

Circular flow of income is the name of the concept which shows how money moves in an economy. This is demonstrated in the diagram below.

Figure 5.1

Figure 5.1 shows the circular flow of income.

From figure 5.1 above, we can see that households have the option of doing two things with their income, spending it on the consumption of goods and services, or saving it. If they choose to save a portion, this amount leaves the circular flow and goes into financial intermediaries.

The commodity market is the market in which goods and services are exchanged for money. Foreign commodities enter the commodity market (imports) and domestic commodities (exports) leave the commodity market. Firms receive their revenue from commodity markets on the sale of their goods and services. That which leaves the firm is known as gross domestic income, this is income before taxation. Taxes are taken from gross national income and paid to the government, who in turn issues transfer payments.

Disposable income is left after taxes are subtracted and are paid to households along with transfer payments. Note that both firms and governments also deposit savings with financial intermediaries. Financial intermediaries then invest this accumulation of money in the commodities market and/or in firms.  Note, that the government also purchases goods and services from the commodity market.

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