Circular+Flow+of+Income,+Sep+2010 (1)

8/8/2019 Circular+Flow+of+Income,+Sep+2010 (1)

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THE CIRCULAR FLOW OF INCOME


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Circular Flow of Income

Economic transactions generate two kinds of flows:

Factor & Product flows : i.e. flow of factors of

production & of goods and services Money flows: factor & product flows generate

money flows in the form of factor payments &

payments for goods and services

These two flows make two kinds of circular flows


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Circular Flow of IncomeBecause land, labor and capital are

generally owned by households, firms must

pay for their useThis payment along with profits become

income and purchasing power that can beused to buy goods and services

These payments are referred to as resourceincome


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Circular Flow of Income The demand for goods andservices by the

recipients of resource income leads to more output,

which in turn brings about additional payments of

resource income

This cyclical operation of demand, output, income,

and new demand is illustrated by the circular flow

of income diagram

The size of the circular flow measures the level ofincome and output in the economy


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The Circular Flow income side

firms buy the factors of production from

households

money payments flow from firms to households

expenditure side

households buy goods and services from firms

money payments flow from households to firms


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The Circular Flow Diagram


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Circular Flow - Simple Model

BusinessesBusinesses HouseholdsHouseholds

Goods and Services

Productive Services

Spending for Goods and Services

Resource Income

RsRs

RsRs

Households offer their productive services to businesses in exchange for

pay in the form of wages, rent, and interest and owners receive profits

Income recipients use their money to buy

goods and services produced by business


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2-8 fig

Goods and services

Consumer

expenditure

Wages, rent

dividends, etc.

Services of factors of production (labour, etc)

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

GOODS MARKETS

FACTOR MARKETS


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The Circular-Flow Diagram

Spending

Goods and

services

bought

Revenue

Goods

and services

sold

Labor, land,

and capital

Income

= Flow of inputs

and outputs

= Flow of dollars

Factors of

production

Wages, rent,

and profit

FIRMS

Produce and sell

goods and services

Hire and use factors

of production

Buy and consume

goods and services

Own and sell factors

of production

HOUSEHOLDS

Households sell

Firms buy

MARKETS

FOR

FACTORS OF PRODUCTION

Firms sell

Households buy

MARKETS

FOR

GOODS AND SERVICES


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Circular Flow can be made more realistic by adding

Government

Banks

External sector


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2-11 fig

Factor

payments

Factor

payments

Consumption of

domestically

produced goods

and services (Cd)

Consumption of

domestically

produced goods

and services (Cd)

Investment (I)Investment (I)

Governmentexpenditure (G)

Governmentexpenditure (G)

Export

expenditure (X)

Export

expenditure (X)

BANKS

Net

saving (S)

Net

saving (S)

GOVT.

Nettaxes (T)

Nettaxes (T)

ABROAD

Importexpenditure (M

Importexpenditure (M

Four Sectors :The circular flow of incomeFour Sectors :The circular flow of income

WITHDRAWALS

INJECTIONS


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Different Measures of the Circular Flow

expenditure side

Consumption

Investment

Government purchases Net exports

income side

purchases of labor, capital, and natural resources for which factor

payments are made

uses of income Saving

Taxes

Consumption


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LeakagesResource income and spending are not

always equal because of

Leakages which flow out of the circularflow that occur when resource income isreceived and not spent directly onpurchases from domestic firms

SavingTaxes

Import purchases


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Injections

However, at least some of these leakages

are returned to the circular flow via variousinjections

Investment

Government spending

Exports


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Stable Economy

Ifallincome is spent

business will sell allgoods, and

will be induced to produce allgoods

again


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Savings and InvestmentIf planned investment(I) = planned savings(S)

so thatinjections = leakages

andtotal spending = total incomeanddemand = supply

then we have a stable economywe have a stable economy


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Contracting EconomyIfleakages exceed injections, we have a

contracting economy resulting in

inventory accumulation

too little spending

drop in prices

and...Planned I < Planned S


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Expanding EconomyIfinjections are more than leakages, we

have an expanding economy resulting in

more goods and services produced

higher prices

and...Planned I > Planned S


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Equilibrium in the Circular Flow

Equilibrium

A stable flow of total output and income

Planned I = planned S

injections =leakages

Price level is stable


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Planned I < planned S

Injections < leakages

Total income and output or the price leveltend to decrease

Income falls, saving decreases until it comes

back into balance with investment


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Planned I > planned S

Injections > leakages

Total income and output tend to increase, ifthe economy is at less than full employment

income and saving increase until it comes into

balance with investment

If the economy is at full employment, the price

level tends to increase


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Government & Circular Flow

Balanced budgetBalanced budget

amount spent by government = amount collected

in taxes Surplus budgetSurplus budget

amount spent by government is less than that

collected in taxes

Deficit budgetDeficit budgetamount spent by government is more than that

collected in taxes


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International Trade & Circular Flow

ImportsImports are a leakage

ExportsExports are an injection

Ifexports = imports, the circular flow is in balance Usually it is not balanced

called a trade deficit, because imports

(leakages) are greater than exports

(injections)


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THE CIRCULAR FLOW OF INCOMETHE CIRCULAR FLOW OF INCOME

Withdrawals

net saving

net taxes

import expenditure

Injections

investment government expenditure

export expenditure

Circular+Flow+of+Income,+Sep+2010 (1)

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