Circular Flow of Income Diagram

Readers Question: How does the Wheel of Income and the National Income Accounting relate to each other and to the Government and Foreign Sector components? How does all this fit on a Wheel of Income?

To be honest I have never heard of the ‘wheel of income’ before. I assume it means the ‘circular flow of income’ which is a much more common economic term.

The circular flow of income refers to a simple economic model which shows the flow of income in an economy. The circular flow of income also show the 3 different methods that National Income is calculated.

1. National Output. Output is produce by firms.

2. National Income. Firms have to pay workers to produce the output. Therefore income flows from firms to households.

3. National Expenditure. With wages from work, households can they buy goods produced by firms. Therefore, the spending goes back to firms.

This represents a simple economic model; it is a closed economy without any government interverntion.

National Income Accounting. There are 3 ways to calculate National Income (GDP)

1. National Output
2. National Income
3. National Expenditure

These 3 methods should give the same result (allowing for accounting discrepencies)

In the real world it is more complicated

4. The government tax firms and consumers and then spends money

5. Foreign sector. We sell exports abroad and buy imports. Therefore, there is a flow of money between one country and the rest of the world.

I will try get a diagram soon, in the meantime you can see this circular flow diagram at Wikipedia.