are the inputs used to produce output: land, labour, capital and enterprise. In return, firms pay **factor incomes**: rent, wages, interest and profit. Firms then produce **goods and services**, which households buy using **consumer expenditure**, often shortened to **consumption** or `C`. ### Real flows and money flows There are two types of flow in the model: - A **real flow** is the movement of actual goods, services or resources. - A **money flow** is the movement of payments, income and spending. So, labour flows from households to firms, while wages flow from firms to households. Goods and services flow from firms to households, while consumer spending flows from households to firms. In the circular flow, money does not simply “disappear” when it is spent. Household spending becomes firms’ revenue; firms’ payments become household income. ## 2. National income, output and expenditure **Gross domestic product**, or **GDP**, is the total value of final goods and services produced within an economy over a period of time. In A-Level macro, GDP is often used as a measure of **national income**. There are three ways to look at the same economic activity: - **National output**: the value of goods and services produced. - **National expenditure**: the value of spending on final goods and services. - **National income**: the value of income earned by factors of production. In theory: $$ \text{National output} = \text{National expenditure} = \text{National income} $$ This is because every final sale creates output, spending and income at the same time. **Value added** is the increase in value created by a firm at a stage of production. It is used to avoid double counting when measuring output. A wheat farmer sells wheat to a bakery for £40. The bakery uses the wheat to make bread and sells the bread to households for £100. 1. The farmer’s value added is £40, because the farmer produces wheat worth £40. 2. The bakery’s value added is £60, because it turns £40 of wheat into £100 of bread. 3. Total output is £100, not £140. Counting both the wheat sale and the bread sale in full would double count the wheat already included in the final bread price. Do not add up every transaction in the production chain. GDP measures the value of **final output**, or the sum of **value added** at each stage. ## 3. The full circular flow model A more realistic circular flow includes more than households and firms. It also includes: - The **financial sector**, such as banks and other institutions that channel savings into borrowing and investment. - The **government sector**, which taxes, spends and provides public services. - The **overseas sector**, meaning households, firms and governments in other countries. An economy that trades with the rest of the world is called an **open economy**. The UK is a highly open economy, so imports and exports matter a lot for the circular flow. ![Circular flow of income with households, firms, injections and leakages](https://assets.yesgenie.com/notes/c55f19ce-43f6-4f4a-8799-21170c247bac.png) ## 4. Leakages: money leaving the main flow A **leakage**, also called a **withdrawal**, is income that is not passed on as spending on domestically produced goods and services. The three main leakages from the circular flow are **savings** `S`, **taxes** `T` and **imports** `M`. ### Savings **Saving** is income not spent on current consumption. If households save more, less income immediately returns to firms as consumer spending. For example, when UK interest rates rose sharply after 2021, saving became more attractive and borrowing became more expensive. This tended to reduce consumption and investment, weakening the circular flow in the short run. ##