Modeling the Economy

This diagram may seem daunting at first, but we will break it down:

Interdependence between economic decision-makers (AO2)

The circular flow of income can be used to explain the relationship between the main economic decision-makers:

• Households: 

  • • Provide firms with factors of production (labor, for example)

    • Spend money on goods and services made by firms

• Firms: 

  • • Reward households with payments for factors of production (wages, for example)

    • Provide households with goods and services

• Government: 

  • • Collects taxes, from both households and firms

    • Spends that tax money into goods and services for both households and firms (education and roads, for example)

• Banks (financial sector):

  • • Households deposit their savings into the bank, instead of spending it on goods and services (leakage)

    • The bank invests that money into firms (injection)

• Foreign sector (foreign households and firms):

  • • The economy spends money importing goods and services from other countries (leakage)

    • The economy receives money exporting goods and services to other countries (injection)

Leakages and injections (AO2)

As you can see in the diagram, there are both leakages and injections in the economy. 

• Leakages occur when money is taken out of the economy. This happens in 3 ways: 

  • • Savings: Instead of spending their money, households save it for later in banks

    • Taxes: The government collects their share, which prevents more money going from households to firms

    • Imports: Households buy products from other countries instead of from their domestic firms

• Injections occur when money is put into the economy. This also happens in 3 ways:

  • • Investments: Savings from earlier can be used to invest now

    • Government spending: The money they collect from taxes is spent back in the economy

    • Exports: Firms sell products to other countries instead of only to domestic households

If injections > leakages, economic activity increases, while if leakages > injections, it declines.