copy of circular flow

Circular Flow Circular Flow

Transactions: The Circular-Flow Transactions: The Circular-Flow DiagramDiagram

Trade takes the form of barter when people directly exchange goods or services that they have for goods or services that they want.

The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle.

National Income and National National Income and National OutputOutput

Macro economy deals with the issues related to the welfare of the whole economy or the national economy

A key issue in macro-economics is the measurement of national income and national output

National Income and National Output are simply define as follow:

– national income – total amount of money generated by an economy in a period of time (usually a year)

– national output – total monetary value of goods and services produced by an economy in a period time (usually a year)


To understand well how national income and national output is measured must study or analyse the relationships between different sectors of the economy

Two types of economy 1) close economy – no international trade2) open economy – there is international

trade A

close economyclose economy

Close economy has three sectors:i. Households – individuals (i.e.

consumers/labourers - owners of resources)ii. Firms – businesses (i.e., sellers/

employers/producers – users of resources)iii. Government – law & order, tax and provider of

collective goods and services


An open economy has four sectors:i. Householdsii. Firmsiii. Governmentiv. Foreign Sector

The relationship between these sectors are used to measure national income and national output

The Circular Flow ModelThe Circular Flow Model

The relationship between the different sectors in an economy is better understood by the using of a circular flow model

A Circular Flow Model – shows the relationship between different

sectors of an economy

Different circular flow models discussed in this course are: 1)Two sector model – households and firms2)Three sector model – households, firms

and government3)Four sector model – households, firms,

government and the foreign sector

Two Sector ModelTwo Sector Model

A two sector model can be a simple or a complex one

1) The simple circular flow model Shows money flows and real flows between

households and firms Households – the owner of resources – land,

labour, capital and enterprise (inputs or factors of production)

Firms – the users of resources (producing goods and services)

TheThe Simple Circular Flow Simple Circular Flow ModelModel

Money flows:– from households to firms in the consumption of

goods and services– from firms to households to pay wages, rents or

profits (factor reward/income)Real Flows:

– goods and services supplied by firms to households

– economic resources of land, capital and labour (factor inputs) supplied by households to firms

The Simple Circular Flow The Simple Circular Flow ModelModel

Under the simple two sector model we assume that:– all money earned (income) by households are

used in consumption – to buy goods and services

– all money earned by firms are used to produce goods and services

– households consumption ( C) = Firms spending or expenditure (E)

Must able to differentiate between money and income

– Money – a stock of dollars at a certain point in time and is sometimes referred to as the money supply

– Income – a flow generated as money travels around the circular flow. Involves velocity of circulation.

– Velocity of circulation – the number of times one unit of money circulates in the circular flow in a given time

The Simple Circular Flow The Simple Circular Flow ModelModel

Under a simple two sector flow model:– all money received by Firms are used in

producing goods and services – all money received by Households are

consumed or used to buy goods and services

Due to the above assumptions, therefore the value of:

– the National output (GDP) - is the total amount obtained by the Firms when producing goods and services

– the National income (NI) - is the total amount earned by Households from factor inputs

The Economic ProblemThe Economic Problem

The circular flow of income

firms and households

goods markets

real flows: goods and services

money flows: consumer expenditure

factor markets

real flows: services of labour and other factors

Goods and services

£Consumer

expenditure

The circular flow of goods and incomesThe circular flow of goods and incomesThe circular flow of goods and incomesThe circular flow of goods and incomes

Goods and services

£Consumer

expenditure

Services of factors of production (labour, etc)


Goods and services

£Consumer

expenditure

Wages, rentdividends, etc.

£

Services of factors of production (labour, etc)


The Circular-Flow DiagramThe Circular-Flow Diagram

Stable EconomyIf all income is spentbusiness will sell all goods, andwill be induced to produce all goods

again

Two Sector Model – Complex Two Sector Model – Complex Circular Flow ModelCircular Flow Model

Now, assume that Households can save part of their income earned

And the Firms changed the composition of output by making consumer goods and capital goods (investments)

– consumer goods – commodities that satisfy consumer’s immediate needs

– capital goods – long lived man-made resources that are used to produce consumer goods. Also known as investment goods

Because of these changes there is injections into the circular flow and withdrawals from the circular flow

Circular Flow ModelCircular Flow Model

Injections, withdrawalsand equilibrium

Circular Flow of IncomeCircular Flow of IncomeThe cyclical operation of demand,

output, income, and new demandLeakages: flows out of circular flow

when resource income is received and not spend directly on purchases from domestic firms

Injections: Added spending in circular flow that does not come out of current resource income

Leakages and InjectionsLeakages and Injections

Leakages in the circular flow savings taxes

Injections in the circular flow investment government spending

The Circular Flow of IncomeThe Circular Flow of Income

Withdrawals

net saving

net taxes

import expenditure

Injections

investment

government expenditure

export expenditure

Injections and Injections and WithdrawalsWithdrawals

Withdrawals – amounts taken out of the circular flow Example of withdrawals for now is savings by Household

Savings (S):amount set aside by Households for future

consumptionreasons for savings include:an emergency ,retirement,future purchase of

consumer goods,future expenses Households can save their money at home or more

commonly nowadays in the bank

Consumption ofdomestically

produced goodsand services (Cd)

The circular flow of incomeThe circular flow of income

Factorpayments




Factorpayments



BANKS, etc

NetNetsaving (S)saving (S)


Factorpayments



BANKS, etc

Investment (I)Investment (I)



Factorpayments



BANKS, etc GOV.



NetNettaxes (T)taxes (T)


Factorpayments



BANKS, etc GOV.


GovernmentGovernmentexpenditure (expenditure (GG))




Factorpayments



BANKS, etc GOV. ABROAD





ImportImportexpenditure (M)expenditure (M)


Factorpayments






ExportExportexpenditure (X)expenditure (X)





Factorpayments










WITHDRAWALSWITHDRAWALS


Factorpayments











WITHDRAWALSWITHDRAWALS

INJECTIONSINJECTIONS

Factorpayments

Regional Purchases ofregionally produced goods

and services OUTSIDE OF REGION



Economic Base Model Collapses Economic Base Model Collapses All Spending into Regional and All Spending into Regional and

Non-Regional Non-Regional

WITHDRAWALWITHDRAWAL

INJECTIONINJECTION


Since the amounts saved are not used in consumption these amounts are not put back to the circular spending flow, therefore savings is regarded as a withdrawal from the circular flow

Injections – amounts put back into the circular flow Example of injections for now is investments (capital

creation) Investments (I):

– buying of new or additional plants and machineries (new investment)

– replacing of worn out capital (replacement investment)


Assumption Injections always equals WithdrawalsWhy?Assume for now that the money saved by

households in the bank are borrowed by producers solely for the purpose of investments or capital creation

That is the Households save (S) and the Firms invest (I)

The Circular Flow of Income The Circular Flow of Income with Government and Foreign with Government and Foreign

TradeTradeGovernment

spends money on goods & services (G)finances welfare payments, i.e. transfer

payments (B)this spending is financed by tax (T)

Export (X)made at home but sold abroad

Import (M)made abroad and bought at home

The Circular Flow of Income in The Circular Flow of Income in SymbolsSymbols

Domestic Output (GDP) is eitherConsumed (C)Invested (I)Bought by the Government (G)Bought by the foreigners, net exports (X-

M)

Factor Incomes are spent onConsumption (C)Saving (S)Paying taxes net of benefits (T-B)


GDP = C + I + G + (X – M)Factor Income = C + S + (T – B)

Since every things produced in the economy

generates equivalent factor income

Domestic Output (GDP) = Factor Incomes


Domestic Output

C + I + G + (X – Z) C + S + (T – B)=

Factor Incomes

C: Consumption I: Investment G: Government ExpenditureX-Z: Net exports

C: Consumed S: Savings T-B: Taxes Net of Benefits


Domestic Output

C + I + G + (X – M) C + S + (T – B)=

Factor Incomes

rearrange

I + G + X S + (T – B) + M=

Total Injections Total Leakages


rearrange

I + G + X S + (T – B) + Z=

S = I + (G – T + B) + (X – Z)

Government Net Expenditure

Net Export


Problem: If the Households loan direct to Firms in the forms of

buying of shares then no problem with our assumption above

But in reality, Households can deposit their money in the bank or sometimes save it in a safety box at home

This causes problems especially if the banks may not lend all money to firms

Also savings and investments are done by different people

Thus planned savings may not always equal planned investment


For example: If savings higher than investments , this will result in:

– not all goods produced are consumed, unplanned stock results in piling up of unsold goods (inventories)

– firms cannot sell all their goods and cut back production– workers may lose their jobs and income fall– as income fall, savings fall

Therefore for equilibrium to exist (injections = withdrawals)

The following conditions are assumed:1) Investment is exogenous (fixed or does not depend on

income)2) Savings are a constant percentage of income


In equation format: Let Y = national output = national income National output (Y) = the sum of consumption goods +

investment goods (I) + changes in stocks (unplanned investment) (ΔR)

Thus: output is Y = C + I + (1)

National Income (Y) = consumptions (C) + savings (S)

Thus: income is Y = C + S (2)


Assume price is constant and other values are in real terms

Then output = income, implies that: C + I = C + S, follows that:

I = S (3) - this is always true, as long as ΔR is zero

That is planned investment (I) = planned savings (S)

Two Sector Model – Complex Two Sector Model – Complex Circular Flow ModelCircular Flow Model

Households Firms

Factor income – wages, profits etc (Y)

Consumption – consumer spending (C)

Banks

Producers

Savings (S)

Investments (I) Injection

Withdrawal

As long as there is no unplanned investments (ΔΔRR = 0), and given everything else remains the same (ceteris paribus) withdrawals always equal injections

That is planned savings (S) (withdrawals) = planned investments ( I )(injections)

Equation:

Output = incomeOutput = income

I + I + ΔΔR +C = C + SR +C = C + S

I + I + ΔΔR = SR = S

If If ΔΔR =0, thenR =0, then

I = S I = S (3)(3)

Three Sector Model – Three Sector Model – Government Include in Circular Government Include in Circular

FlowFlow In a three sector model the Government sector is

included as part of the circular flow model How does the Government affect the equilibrium

in the circular flow model?1) Withdraw amounts from the circular flow

through taxes (T) – transfer payments2) Inject amounts into the circular flow through

government purchases - expenditure These Government actions affect both Households

and Firms


FlowFlow Points to note: Taxes gain by Government is the net of taxes after transfers

has been deducted That is: Net taxes = T = Taxes – Transfer payments Why transfer payments are not included in government

purchases? – transfer payments do not require that the recipient

produce a good or service in order to receive them– examples of transfers payments include social security,

welfare, and unemployment benefits– these are regarded as compensation and are not counted

in government purchases


FlowFlow Points to note: Transfer payments and government purchases are both

parts of government spending

But government purchases are represented on a circular flow diagram as flows of money from government to firms and goods and services from firms to government

Government Purchases - are the sum of purchases of goods and services from firms by government agencies, plus the total value of output produced by government agencies


FlowFlow The Government sector is now included in

the circular flow model but the equilibrium condition of withdrawals = injections remains (i.e., income = output)

Thus equation (1) & (2) are extended to include Government purchases (G) and Government net taxes (T)

Output: Y = C + I + G (Injections) (4) Income: Y = C + S + T (Withdrawals) (5)


FlowFlowAnd since Output = Income, and with

further manipulations we arrive at the following equation (6)

S + T = I + G (6) (withdrawals = injections)

The Circular FlowThe Circular Flow

Goods

Other countriesOther countries

Financial marketsFinancial markets

GovernmentGovernmentFirms

(production)HouseholdTaxes

Factor services

SavingsImports

Government

Spending

Wages, rents, interest, profits

Exports

Investment

Personal consumption

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Savings and InvestmentSavings and Investment

If planned (I+G) = planned (S+T)so that injections = leakages

and total spending = total incomeand demand = supply

then we have a stable economywe have a stable economy

Contracting EconomyContracting Economy

If leakages are HigherHigher than injections (Planned S+T > Planned I+G), economy contracts resulting ininventory accumulationtoo little spendingdrop in prices

Expanding EconomyExpanding Economy

If injections are HigherHigher than leakages (Planned I+G > Planned S+T), economy expands resulting inmore goods and services producedhigher prices

Government and the Government and the Circular FlowCircular Flow

Balanced budget: amount spent by government = amount

collected in taxesSurplus budget

amount spent by government is less than that collected in taxes

Deficit budget amount spent by government is more than that

collected in taxes

International Trade and the International Trade and the Circular FlowCircular Flow

IMPORTSIMPORTS are a leakage EXPORTSEXPORTS are an injection If exports = imports, the circular flow is in

balance Usually it is not balanced

called a trade deficit, because imports (leakages) are greater than exports (injections)

Four Sector Model – Foreign Four Sector Model – Foreign Sector Include in Circular FlowSector Include in Circular Flow

In a four sector model the Foreign sector is included as part of the circular flow model

How does the Foreign sector affect the equilibrium in the circular flow model?1)Withdraw amounts from the circular flow

through import payments (M)2)Inject amounts into the circular flow through

export receipts (X)


The Foreign sector is now included in the circular flow model but the equilibrium condition of withdrawals = injections remains (i.e., income = output)

Thus equation (4) & (5) are extended to include Export receipts (X) and import payments (M)

Output: Y = C + I + ΔR + G + X (Injections) (7)

Income: Y = C + S + T + M (Withdrawals) (8)


And since Output = Income, and with further manipulations and assuming ΔR is zero we arrive at the following equation (9)

S + T + M = I + G + X (9) (withdrawals = injections)


Households Firms

Factor income – wages, profits etc (Y)

Consumption – consumer spending (C)

Banks

Producers

Savings (S)

Investments (I) Injection

Withdrawal

Equation:

Output = incomeOutput = income

Injections = withdrawalsInjections = withdrawals

I + I + ΔΔR +C+ G + X = C + S +T + MR +C+ G + X = C + S +T + M

I + I + ΔΔR + G + X = S + T + MR + G + X = S + T + M

If If ΔΔR =0, thenR =0, then

I + G + M = S + T +I + G + M = S + T + X (9) X (9)

Government

(Net taxes (T))

Purchases/spending (G)

Transfers Taxes

withdrawal

Foreign Sector

Import payments (M)

Export receipts (X)

Factorpayments

Factorpayments






Governmentexpenditure (G)

Governmentexpenditure (G)

Exportexpenditure (X)

Exportexpenditure (X)

BANKS, etc

Netsaving (S)

Netsaving (S)

GOV.

Nettaxes (T)

Nettaxes (T)

ABROAD

Importexpenditure (M)

Importexpenditure (M)


WITHDRAWALS

INJECTIONS

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