Government

Circular Flow in Economics

The Circular-Flow DiagramCircular Flow in Economics: How households and businesses interact in the market for resources and in the market for goods and services, and see how money keeps the whole process moving.The circular flow model highlights the “flows” within the economy―the flow of economic resources, goods and services, and the flow of money.

The Circular-Flow Diagram…… is a simple depiction of the macroeconomy.

… illustrates GDP as spending, revenue, factor payments, and income.

First, some preliminaries:Factors of production are inputs like labor,

land, capital, and natural resources. Factor payments are payments to the factors

of production. (e.g., wages, rent)

The Circular-Flow Diagram

Households: own the factors of production,

sell/rent them to firms for income buy and consume Goods &

Services (g&s)

Households: own the factors of production,

sell/rent them to firms for income buy and consume Goods &

Services (g&s)

HouseholdsFirms

The Circular-Flow Diagram

HouseholdsFirms

Firms: buy/hire factors of production,

use them to produce g&s sell Goods & Services (g&s)

Firms: buy/hire factors of production,

use them to produce g&s sell Goods & Services (g&s)

The Circular-Flow Diagram

Markets for Factors of Production

HouseholdsFirms

Income Wages, rent, profit

Factors of production

Labor, land, capital

Spending

G & S bought

G & S sold

RevenueMarkets for Goods & Services

What This Diagram Omits…The government

collects taxespurchases g&s

The financial systemmatches savers’ supply of funds with

borrowers’ demand for loans

The foreign sectortrades g&s, financial assets, and currencies

with the country’s residents

Expanded Circular Flow

Goods

Other countries

Financial markets

GovernmentFirms

(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.

Households earn income via the factor markets from wages, interest on bonds, dividends on stocks, and rent on land.

Via the financial markets, private savings is channeled to firms for investment spending.

Government purchases of goods and services is paid for by tax receipts as well as by government borrowing.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

The expanded circular flow diagram shows the transactions among households, firms, governments, and the rest of the world.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

These transactions take place in factor markets, goods markets, and financial markets.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

Households buy consumer goods and services. The red flow, C, shows consumption expenditures.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

Households save, S, and pay taxes, T. Firms borrow some of what households save to finance their investment.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

Firms buy capital goods from other firms. The red flow I represents this investment expenditure by firms.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than taxes.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

The rest of the world buys goods and services from us, X, and sells us goods and services, M—net exports are X - M

Exports (X) generate an inflow of funds into the country from the rest of the world

Imports (M) lead to an outflow of funds to the rest of the world.

Foreigners can also buy stocks and bonds in the U.S. financial markets.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

The blue and red flows are the circular flow of expenditure and income. The green flows are borrowing and lending.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

The sum of the red flows equals the blue flow.

Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

That is: Y = C + I + G + X - M

An Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

SUMMARY: The Circular Flow… Matching Buyers and Sellers

Market for Factors

Market for Goods and Services

FirmsHouseholds

Factor PaymentsIncome

Firm RevenueConsumption

Labor, Land, and Capital for Sale

Labor, Land, and Capital Purchased

Goods and Services for Sale

Goods and Services

Purchased

Businesses provide final goods and services to

households…

…who in turn pay for them with money.

Households “sell” resources to businesses…

…who in turn pay for them with wages, rent, interest, and profits.

SUMMARY: The Circular Flow… Matching Borrowers and Lenders

Market for Factors

Market for Goods and Services

Firms

Households

Financial Markets

Government

Factor PaymentsIncome

Firm RevenueConsumption

Public Savings

Government Spending

Interest

Loans

Private Savings

Taxes

Transfers Transfers

Taxes

Interest

Individuals and governments earn a rate of return from their savings

Businesses can borrow from the bank to obtain capital to purchase inventory

Circular Flow

Expanded Circular Flow