copy of circular flow
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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)
National Income and National National Income and National OutputOutput
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
National Income and National National Income and National OutputOutput
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)
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)
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
Wages, rentdividends, etc.
£
Services of factors of production (labour, etc)
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
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
Consumption ofdomestically
produced goodsand services (Cd)
The circular flow of incomeThe circular flow of income
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
BANKS, etc
NetNetsaving (S)saving (S)
The circular flow of incomeThe circular flow of income
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
BANKS, etc
Investment (I)Investment (I)
NetNetsaving (S)saving (S)
The circular flow of incomeThe circular flow of income
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
BANKS, etc GOV.
Investment (I)Investment (I)
NetNetsaving (S)saving (S)
NetNettaxes (T)taxes (T)
The circular flow of incomeThe circular flow of income
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
BANKS, etc GOV.
Investment (I)Investment (I)
GovernmentGovernmentexpenditure (expenditure (GG))
NetNetsaving (S)saving (S)
NetNettaxes (T)taxes (T)
The circular flow of incomeThe circular flow of income
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
BANKS, etc GOV. ABROAD
Investment (I)Investment (I)
GovernmentGovernmentexpenditure (expenditure (GG))
NetNetsaving (S)saving (S)
NetNettaxes (T)taxes (T)
ImportImportexpenditure (M)expenditure (M)
The circular flow of incomeThe circular flow of income
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
BANKS, etc GOV. ABROAD
Investment (I)Investment (I)
GovernmentGovernmentexpenditure (expenditure (GG))
ExportExportexpenditure (X)expenditure (X)
NetNetsaving (S)saving (S)
NetNettaxes (T)taxes (T)
ImportImportexpenditure (M)expenditure (M)
The circular flow of incomeThe circular flow of income
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
BANKS, etc GOV. ABROAD
Investment (I)Investment (I)
GovernmentGovernmentexpenditure (expenditure (GG))
ExportExportexpenditure (X)expenditure (X)
NetNetsaving (S)saving (S)
NetNettaxes (T)taxes (T)
ImportImportexpenditure (M)expenditure (M)
WITHDRAWALSWITHDRAWALS
The circular flow of incomeThe circular flow of income
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
BANKS, etc GOV. ABROAD
Investment (I)Investment (I)
GovernmentGovernmentexpenditure (expenditure (GG))
ExportExportexpenditure (X)expenditure (X)
NetNetsaving (S)saving (S)
NetNettaxes (T)taxes (T)
ImportImportexpenditure (M)expenditure (M)
The circular flow of incomeThe circular flow of income
WITHDRAWALSWITHDRAWALS
INJECTIONSINJECTIONS
Factorpayments
Regional Purchases ofregionally produced goods
and services OUTSIDE OF REGION
ExportExportexpenditure (X)expenditure (X)
ImportImportexpenditure (M)expenditure (M)
Economic Base Model Collapses Economic Base Model Collapses All Spending into Regional and All Spending into Regional and
Non-Regional Non-Regional
WITHDRAWALWITHDRAWAL
INJECTIONINJECTION
Injections and Injections and WithdrawalsWithdrawals
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)
Injections and Injections and WithdrawalsWithdrawals
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)
The Circular Flow of Income in The Circular Flow of Income in SymbolsSymbols
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
The Circular Flow of Income in The Circular Flow of Income in SymbolsSymbols
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
The Circular Flow of Income in The Circular Flow of Income in SymbolsSymbols
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
The Circular Flow of Income in The Circular Flow of Income in SymbolsSymbols
rearrange
I + G + X S + (T – B) + Z=
S = I + (G – T + B) + (X – Z)
Government Net Expenditure
Net Export
Injections and Injections and WithdrawalsWithdrawals
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
Injections and Injections and WithdrawalsWithdrawals
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
Injections and Injections and WithdrawalsWithdrawals
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)
Injections and Injections and WithdrawalsWithdrawals
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
Three Sector Model – Three Sector Model – Government Include in Circular Government Include in Circular
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
Three Sector Model – Three Sector Model – Government Include in Circular Government Include in Circular
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
Three Sector Model – Three Sector Model – Government Include in Circular Government Include in Circular
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)
Three Sector Model – Three Sector Model – Government Include in Circular Government Include in Circular
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)
Four Sector Model – Foreign Four Sector Model – Foreign Sector Include in Circular FlowSector Include in Circular Flow
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)
Four Sector Model – Foreign Four Sector Model – Foreign Sector Include in Circular FlowSector Include in Circular Flow
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)
Four Sector Model – Foreign Four Sector Model – Foreign Sector Include in Circular FlowSector Include in Circular Flow
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
Consumption ofdomestically
produced goodsand services (Cd)
Consumption ofdomestically
produced goodsand services (Cd)
Investment (I)Investment (I)
Governmentexpenditure (G)
Governmentexpenditure (G)
Exportexpenditure (X)
Exportexpenditure (X)
BANKS, etc
Netsaving (S)
Netsaving (S)
GOV.
Nettaxes (T)
Nettaxes (T)
ABROAD
Importexpenditure (M)
Importexpenditure (M)
The circular flow of incomeThe circular flow of income
WITHDRAWALS
INJECTIONS