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Circular-Flow Model

2Product Market

Resource Market

Businesses IndividualsGovernmentPublic GoodsPublic Goods

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Transfer PaymentsSubsidies

Copyright

ACDC Leadership 2015

Two Types of Markets

The Product Market-

•The “place” where goods and services

produced by businesses are sold to

households.

The Resource (Factor) Market-

•The “place” where resources (land, labor,

capital, and entrepreneurship) are sold to

businesses.

Two market types are featured in the circular flow. The circular flow of a nation’s economy is based on the exchanges that take place in two markets where buyers and sellers meet.

Circular Flow Model Vocab

Private Sector- Part of the economy that is run by individuals and businesses

Public Sector- Part of the economy that is controlled by the government

Factor Payments- Payment for the factors of production, namely rent, wages, interest, and profit

Transfer Payments- When the government redistributes income (ex: welfare, social security)

Subsidies- Government payments to businesses

Resource Market These are the markets in which business firms acquire productive

resources from households. Resource markets include:

Labor MarketsHouseholds provide labor to firms. In exchange for their labor, households receive money payments from firms in the form of wages.

If a business owner is self employed, the opportunity cost of working for himself or herself is the wages he or she could have earned working for someone else.



Capital MarketsHouseholds who save provide financial capital to banks, which make loans to firms wishing to acquire new physical capital. In exchange for their physical capital, households receive money payments in the form of interest.

If a business owner uses his or her own finances to acquire capital for his or her business, the opportunity cost of spending money on capital is the interest that could have been earned saving the money in a bank.



Land Markets Firms may need to rent the space in which they operate their business. Households that own the land, retail, warehouse, or factory space receive rent from firms in exchange for its use.

If the business owner uses his or her own land in production, the opportunity cost of using the self-owned resources is the rent he or she could have earned by renting the land out to another business.



EntrepreneurialThough markets for entrepreneurial ability are often not as formal, profit serves as a cue to entrepreneurs, pulling them toward better business opportunities.

Because the innovative talents for combining the other three resources are owned by the entrepreneur, the opportunity cost of using these self-owned talents is known as normal profit, or the amount that the business owner could have earned putting those talents to use doing something else (running a different business or working for someone else).

Product MarketThis represents the markets in which households demand

the goods and services produced by firms.

Goods refers to any physical products such as food, clothes, cars, and televisions.

Services refers to non-tangible products such as legal and financial services, haircuts, taxi rides, tourism, and education.

THE FIVE CONTRIBUTORS TO THE ECONOMIC ACTIVITY IN A NATION’S ECONOMY

1. Households

Domestic households demand goods and services in the product market; supply land, labor, and capital in the resource market; pay taxes to the government, receive transfer payments and the provision of public goods from the government; and demand imports from foreign countries.1.


2. Firms

Domestic business firms produce many of the goods and services consumed by households. Firms demand productive resources (land, labor, and capital) from households in the resource market. Firms pay taxes to the government and enjoy public goods and services provided by the government. Some firms sell their output to foreign consumers and demand resources from foreign households.


3. Government Sector

The macroeconomic circular flow model includes the government, which collects taxes from households and firms, redistributes income through transfer payments and the provision of public goods to the nation, and provides infrastructure and the legal structure that protects the property rights of private individuals and firms, creating an environment for the market economy to function.


4. Foreign SectorIn an open economy, both domestic households and firms demand goods, services, and productive resources from foreigners. In addition, foreigners demand some of a nation’s output.

i. Imports from abroad are leakages from a nation’s circular flow, since money leaves the nation’s economy in order to purchase these goods.

ii. Exports to foreigners are injections into the circular flow, since money enters the nation’s economy as payment for these exports.


5. Banking Sector

The banking sector facilitates the flow of capital from households to firms.

i. Money saved by households in banks is a leakage from the circular flow, since it is money not being spent on goods and services.

ii. Money lent to firms or households for investment is an injection into the circular flow, since firms are spending on new capital, leading to more employment and output.

iii. A bank functions as a convenient intermediary, allowing lenders and borrowers to do business finding one another.

INJECTIONS AND LEAKAGES

The flow of money in a nation experiences constant injections and leakages.

1. Injections create more spending, production, and employment in an economy and thus increase the overall size of the nation’s economy.

2. Leakages reduce the amount of spending, production, and employment in a nation, and thus reduce the overall size of the nation’s economy.


The Government Sector

Leakages: Taxes paid by households and firms on income, revenues, profits, and consumption reduce the flow of income in the economy. Money paid to the government is money households or firms cannot spend on goods, services, or investments in capital and labor.



Injections: Government provides goods and services to the nation’s households and firms as well as transferring payments that redistributes the nation’s income. Goods and services provided by government include education, infrastructure, the legal and judicial system, public safety, national defense, and others. Transfer payments include government programs that transfer the nation’s income from certain taxpayers to other stakeholders such as welfare, unemployment, Social Security, subsidies to certain producers, and financial aid for education.



When government pulls more money out of the circular flow in taxes than it injects

through spending, it is acting to slow the economy down and running a budget surplus. If government spends more than it taxes, it is acting to stimulate the economy and running

a budget deficit.


The Banking Sector

Leakages: Money saved in banks by households and firms is considered a leakage from the circular flow, because money saved is money not spent on output, not going toward creating employment.


The Banking Sector

Injections: Money borrowed from banks by households and firms to finance spending on consumer goods and capital goods is an injection into the circular flow, because such spending leads to more employment, increasing the nation’s output and the income of households.


The Foreign Sector

Leakages: Import spending by domestic households on foreign-produced goods and services is leakage from the nation’s circular flow because that money is not being spent on domestic output and is not going to contribute to domestic employment.


The Foreign Sector

Injections: Export revenues from the sale of goods and services to foreign households and firms is an injection into the nation’s circular flow because it creates greater demand for the nation’s output, increasing employment and income among domestic households.

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