Circular Flow

• Circular flow model:

  • A representation of the economy showing how economic participants interact with each other
  • Divides the economy into participants and indicates how they engage in economic activities
  • Shows the movement of income, production, and spending between role players in the economy
  • Basic purpose is to understand how money moves within an economy
• Open circular flow model:

  • An economy that imports and exports goods and services to and from other countries
  • Includes participants like households, firms, government, and the foreign sector
  • Real flows: flow of goods and services between participants
  • Money flows: flow of income and expenditure between participants
• Households interaction:

  • Own factors of production and sell them in the factor market to firms
  • Receive remuneration from firms in the form of wages, salaries, interest, rent, and profit
  • Use income to buy goods and services from businesses, pay taxes, save, and buy goods from other countries
  • Major consumers of economic goods and services
• Firms/businesses interaction:

  • Buy factors of production from households to produce goods and services
  • Sell goods and services to households, government, and foreign sector
  • Use earnings to invest in producing more goods, borrow funds, pay taxes
• Government/state interaction:

  • Receives revenue from households, firms, and foreign sector in the form of taxes
  • Provides public goods and services, pays subsidies, grants, borrows funds
• Foreign sector interaction:

  • Imports flow to households, firms, and government
  • Exports flow from firms and households to other countries
  • Receipts for exports flow to firms, households, and government
  • Payments for imports flow to firms, households, and government
• Real flows:

  • Flow of actual goods or services
  • Include factors of production, wages, salaries, and goods and services exchanged between participants
• Money flows:

  • Flow of income and expenditure
  • Include payments for factors of production, consumption spending, taxes, and payments for goods and services
• Injections:

  • Introduction of additional money into the economy by investment, government spending, and exports
  • Types of injections: investment, government spending, and exports
  • Increase economic activities in the economy
• Injections increase money in the circular flow of income through investments, government expenditure and exports
• Leakages withdraw money from the circular flow of income through savings, taxes and imports
• The economy will be in equilibrium when injections are equal to leakages (J=L)
• The economy will be in disequilibrium when injections are not equal to leakages
• If leakages are greater than injections, it leads to a decrease in national income
• If injections are greater than leakages, it leads to an increase in national income
• Autonomous spending is the consumption spending independent of income
• The government can use fiscal policy to influence the economy.
• It occurs even when income levels are zero
• Amount of money that households need to spend to stay alive regardless of income
• Occurs only when expenditure on consumables does not vary with changes in income
• Spending required to fund necessities and debt obligations
• Factor market is where factors of production are traded
• Goods market is where goods and services are traded
• Financial market is where short and long term financial assets are traded
• Supply refers to the quantity of a good or service that producers are willing to offer at a given price.
• Capital market is where producers and consumers make long-term deposits and borrow
• Money market is the market for short-term savings and loans
• Demand refers to the quantity of a good or service that consumers are willing to buy at a given price.
• Foreign exchange market is where one currency can be traded for another
• The financial market provides savings facility to households, pays interest and dividends, facilitates borrowing for firms and government
• The price of a good or service depends on the interaction between supply and demand.
• Two markets that form part of the financial system are the capital market and the money market
• The financial sector is important in the circular flow as it facilitates the flow of funds between participants, stimulating economic activities and business expansion
• Factor markets are where factors of production are traded, while product markets are where goods and services are traded
• Fiscal policy involves changing tax rates or government spending levels.
• Factor markets include all markets where labor, resource, and capital are bought and sold
• Examples of product markets include durable and non-durable goods
• An open economy is best described as a three-sector economy
• Investment is an example of an injection in the circular flow model
• Real GDP growth measures the increase in the production of goods and services in an economy after adjusting for price changes. >