the circular flow model

The Circular Flow Model


Shows the economic transactions that occur between households, firms and other sectors in the economy.

Money flows- We will only focus money flows as it is simpler than trying to account for the physical flows.

The Circular Flow of Income and Spending

The simplest form of circular flow

HouseholdsProducers

Incomes $ rent wages interest profit

$ Consumption

Goods and Services

Factors of production

(Land, Labour, Capital

Introduction of the Financial Sector

a

b

d

c

Households Producers

Financial Institutions

C (Payments for goods and services)

Y (Income)

S (savings)

I (Investment)

The financial Sector • Households do not spend all the income they earn

they also save some.

• Savings = Income – Consumption

• Households usually save their income with banks.

• Banks then use this money to lend to firms.

• Firms then use these loans for investment (purchase capital)

Interest • When firms borrow from banks they pay interest in return for

these loans.

• Banks however, also pay interest to households for saving money with them.

• BUT!

• Banks will charge a higher interest to borrowers than what they pay to savers. This is how they make an income.

• E.g Joe saves 100 with BNZ and earns 5% interest in return for saving. BNZ then loans some of this money out but charges 10% for loans.

Open Economy

• Not all goods available in NZ are produced in NZ. – Imports = Goods made overseas but sold in

NZ

• Not all goods produced in NZ are sold here. – Exports = Goods made in NZ but sold

overseas

• Exports and Imports are real flows. They are actual goods and services being traded internationally.

Producers

Overseas Sector

Imports

Exports

Money Flows– Export receipts= payments from

overseas firms to NZ firms for the goods and services exported overseas.

– Import Payments = NZ producers payments to overseas firms for the goods and services they have imported.

– Remember export receipts are coming into NZ

– Import payments are leaving NZ

Producers

Overseas Sector

Imports

Exports

Export Receipts

Import Payments

An Open Economy

a

b

c

d

f

g

HouseholdsProducers


Overseas Sector

C (consumption)

Y (Income)

S (Savings)

I (Investment)

X (Export receipts)

M (Import payments)

Role of the Government• The government collects taxes

– PAYE (pay as you earn) Income tax– GST (goods and services tax) 15% tax on any good or service you consume.– Company Tax – Taxes paid by producers to the government

• Transfers – Subsidies that go to producers– Social Welfare- (Sickness benefit, superannuation, unemployment benefit) this

flow goes straight to households.

• Government Spending – Providing goods and services. (Schools, hospitals and the police force)– Payment for goods and services

Role of the Government

a

b

c

d

f

g

HouseholdsProducers


Overseas Sector

C (consumption)

Y (Income)

S (Savings)

I (Investment)

X (Export receipts)

M (Import payments)

Government

a b

c

tr (transfers)

T (taxes)

G (Government Spending)


a

b

c

d

e

f

h g

i

C (consumption)

HouseholdsProducer


Overseas Sector

Y (Income)

S (Savings)

I (Investment)

X (Export receipts)

M (Import payments)

T (taxes)

tr (transfers)

G (Government Spending)

Government

The Circular Flow model Y= Incomes including rent wages interest and profit C= Consumption spending- the payment for goods and

services S= Savings – income not spent on consumption this is a

withdrawal from the economy I= Investment spending-purchase of capital goods. This is

an injection into the economy X= Export receipts- Money received for exports sold M= Import payments- Payments made for imports

purchased G= Government Spending- on collective goods T= Taxes the government collects from households and

firms. These are used to fund G and Tr. Tr= Transfer money from one group to another, because of

this transfer payments are not true expenditure.

Withdrawals and Injections• Withdrawal = A money flow that leaves the

circular flow – I= Investment spending-purchase of capital goods. This is an

injection into the economy– X= Export receipts- Money received for exports sold– G= Government Spending- on collective goods

• Injection= Flows of money into the circular flow model– S= Savings – income not spent on consumption this is a

withdrawal from the economy – M= Import payments- Payments made for imports purchased – T= Taxes the government collects from households and firms.

These are used to fund G and Tr.

Money and Real Flows - Notes

• Money Flow – are the payments made for goods purchased or the services being provided. – E.g the payment of wages in return for the use of labour

• Real Flow – are the movements of actual goods and services between different sectors of the economy– E.g. the use of labour by a producer

the circular flow model

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