The Circular Flow of Economic Activity

Review of Microeconomic Activities:

ECONOMIC ACTIVITY

HOUSEHOLDS

FIRMS

Markets for goods and services

Markets for factors (inputs) of production

Markets for goods and services

Markets for factors (inputs) of production

Buyers

Sellers

Review of Microeconomic Activities:

ECONOMIC GOAL

HOUSEHOLDS

FIRMS

As

Buyers

As Sellers

Optimal satisfaction Minimal

Cost

Maximum Income

Profit Maximizatio

n

Review of Microeconomic Activities:

ECONOMIC BENEFITS

HOUSEHOLDS

FIRMS

Surplus Consumer

SurplusProducer Surplus

From Microeconomic Analysis to Macroeconomic Analysis:

First, analysis of markets (microeconomics)

Next, analysis of economic sectors (macroeconomics): 2-Sector Circular Flow (basic sectors

directly connected to the markets; basic economy)

5-Sector Circular Flow (3 additional sectors to complete the economy)

The Basic (2-Sector) Circular Flow Model

a simple economic model which describes the reciprocal circulation of income between producers and consumers.

In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income.

Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households.

The Basic 2-Sector Circular Flow Model (w/ details)

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Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of money

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

The Basic (2-Sector Circular Flow Model

The Basic (2-Sector Circular Flow Model

Assumptions: (ideal situation)

The economy consists of two sectors: households and firms.

Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).

All output (O) produced by firms is purchased by households through their expenditure (E).

There is no financial sector. There is no government sector. There is no international sector.

The Basic Circular Flow Model

The Simple Maths:

Y = E E = C C = O

/.: Income Perspective: Y = C

The 5-Sector Model

A more realistic representation of the economy.

Unlike the two sector model where there are six assumptions the five sector circular flow relaxes all six assumptions.

Since the first assumption is relaxed there are three more sectors introduced.

The 5-Sector Model

The Three Additional Sectors: The Financial Sector The Government Sector The International (or Overseas) Sector

The 5-Sector Model

FINANCIAL SECTOR

GOVERNMENT SECTOR

INTERNATIONAL SECTOR

FIRMSHOUSEHOLDSOutput

(O)

Resources

Consumption/Expenditures (E)

Income (Y)

Savings (S)

Taxation (T)

Imports (M)

Investments (I)

Government Spending

(G)

Exports (X)

L E A

K A

G E

S

INJE

CTIO

NS

The 5-Sector Model

LEAKAGES

Savings (S)

Taxes (T)

Imports (M)

INJECTIONS

Investments (I)

GovernmentSpending (G)

Exports (X)

FINANCIAL SECTOR

GOVERNMENT SECTOR

INTERNATIONAL SECTOR

The Basic Circular Flow Model

The Simple Maths:Since Y = C + S + T + M

Y= C + I + G + X

Then, S + T + M = I + G + X (Leakages) (Injections)

The Basic Circular Flow Model

IF:

S + T + M = I + G + X

S + T + M > I + G + X

S + T + M < I + G + X

THEN, WE HAVE A:

More or less Stable Economy.

Contracting or Shrinking Economy.

Growing economy.