H2 Intro to Macro: Circular Flow of Income

What is the main purpose of the Circular Flow of Income model in economics?

• To illustrate the flow of money and resources

• To predict stock market trends

• To measure inflation rates

• To analyse government spending

Answer explanation

The circular flow of income model simplifies the complex interactions in an economy by visualising the flow of money, goods, and services between key sectors.

In the Circular Flow of Income model, which of the following best describes the relationship between firms and household in the factor market?

• Firms supply factors of production.

• Firms are consumers of goods and services in the factor market.

• Firms do not interact with households in the factor market.

• Firms demand factors of production provided by households.

Answer explanation

In the factor market, firms demand for factors of production (e.g. labour services, capital machinery) provided by households who are factor owners.

In the Circular Flow of Income model, what factor payment does a capital owner and entrepreneur receive, respectively?

• Interest, Wages

• Interest, Profit

• Wages, Profit

• Rent, Profit

Answer explanation

Income flows to households as factor payments. The factor income that capital owners receive is an example of interest. The factor income that entrepreneur receives is profits. The factor income that labour receives is wages, while the factor income that land owners receive is rent.

How does the Circular Flow of Income model illustrate the concept of economic equilibrium?

• By analyzing trade balances

• By predicting future economic growth

• By showing equal levels of income and expenditure

• By measuring unemployment rates

In the circular flow of income model, income that is not passed on into the circular flow is known as

• rejection

• injection

• withdrawals

• savings

Answer explanation

Withdrawals are incomes of households and firms that are not passed on into the circular flow.

In the Circular Flow of Income model, which of the following is considered an injection?

• Taxes

• Imports

• Government spending

• Savings

What effect does an increase in savings have on the Circular Flow of Income?

• It leads to higher government spending.

• It has no effect on national income

• It decreases overall national income.

• It increases overall national income.

Answer explanation

Savings is an example of a leakage / withdrawal which would lead to a decrease in national income as less income is spent and passed on.

What role do households play in the Circular Flow of Income model?

• They provide goods and services to firms.

• They receive wages and salaries from firms.

• They are the primary source of government revenue.

• They do not participate in the economy.

Answer explanation

Households are also factor owners which provide factor of production to firms. In turn, they receive factor income / payments such as wages, rents and interest from firms.

How do imports affect the Circular Flow of Income?

• They increase national income.

• They lead to higher savings rates.

• They decrease the flow of money within the economy.

• They have no impact on the economy.

Suppose government increases the corporate tax rates of firms. How would the circular flow of income be affected?

Answer explanation

Consider the following situation where injections exceed withdrawals. For example, if the government decides to increase government spending (G) by building a new university, this increase in government expenditure goes to the construction firms who are building the new university. These construction firms will in turn spend on construction materials, and firms selling these construction materials would receive this payment. The construction and materials firms will then pay their workers, resulting in an increase in factor income. This induces households to not only spend more on domestic goods and services, but also save more, pay more taxes and buy more imports. In other words, withdrawals will rise to match the increase in injection initially. The resultant is an expanded circular flow of income.