Unit 3 Our Economy 3.10 3.11 LO 3.2 3. How does an economy work?
In order to begin to understand economics from the macroeconomic (national) level, it is very useful to look at the circular flow of income in an economy.
Simple circular flow of income Households and businesses are the two most important players in the economy. They are the source of all income and expenditure. Money flows in a circle between these two groups. Households work for businesses in return for wages, and with that income households buy goods and services from businesses.
Provide work and buy goods & services
Households
Provide goods & services and pay wages
Circular flow of income including the government The government also plays a very important role in the circular flow of income. The government takes money out of the circular flow of income through taxes. This is called a ‘leakage’ in the economy. They also make ‘injections’ of money into the economy, through expenditure and payments to households and businesses. This injection of money can be in the form of wages for civil servants, spending on infrastructure, grants to businesses and social welfare payments. For example, when the government wants to open a new school they pay a construction company to build it and then pay the salaries of teachers to work in the school. By collecting taxes and spending money, the government plays an important role in how much money circulates in the economy.
Businesses
(commercial and not-for-profit)
Households Payments Taxation Expenditure 372 Government (all public sector organisations)
Businesses (all private and commercial and not-for- profit organisations)
