Circular Flow and Economic Growth: Understanding the Basics

Circular Flow Mechanism

In any economy, there are many transactions and exchanges. The circular income flow expresses the relationships between simplified economic actors. We consider an economy where only two economic agents are considered:

• The domestic economy: They own the factors of production, which they provide to businesses, and earn an income with which to purchase goods and services.
• Businesses: They produce goods or services sold in the market, and with the income they get, they pay for the productive factors.

Companies provide families with goods and services that they demand. There are two types of flow:

• The real flow: This reflects the goods and services produced by businesses. The sum of the production of all companies is called the National Product (NP).
• The flow of money: This is the spending made by families to purchase goods and services. The sum of this expenditure is the National Expenditure (NE).

There are two distinct flows:

• Real flow: This represents the factors of production used to carry out the process of preparing goods and services.
• Cash flow: This is established by the income families receive. The sum of all income is the National Income (NI).

The relationships established between families and businesses can be described as a circular flow in which some sell and others buy. It follows that: NP = NI = NE. The incomes that have been spent in acquiring the goods and services produced by firms.

National product can be calculated in three ways:

• By way of production: The value of production of businesses in a country in a given period.
• By way of costs: The sum of the costs incurred by operators in the purchase of goods and services.
• By way of income: This takes the total income received by the staff carrying out the production process.

Economic Growth

Economic growth is a sustained process over a long time in which the levels of economic activity rise constantly. Economic growth is measured by:

• GDP growth rate (real).
• The level of real GDP per capita.

Economic growth refers to an increase in actual production and production potential. Short-term economic growth and long-term growth: The economy is at a point inside the Production Possibilities Frontier (PPF) when not all resources are being used. When all resources are used, the economy is located on the PPF. With short-term policies, the goal of full employment can be achieved, and the economy can reach a point on the curve. The amount of production will be limited.

Long-term growth requires that the PPF shifts outward. Economic growth is often associated with increasing the productive capacity of a country's potential GDP. It acts on aggregate supply.

The Determinants of Economic Growth

• Increased physical capital: It is a scarce resource and a determinant of productivity. Workers will increase their productivity if they have better equipment to work with.
• Improving human capital: Qualification has been considered by some to be the determining factor of economic growth. It is key because it contributes to increased productivity.
• Technological advances: The ideas generated by research and development usually allow the emergence of new products and production methods.