Chapter 8 The Circular Flow Model 2003 SouthWestern

Chapter 8 The Circular Flow Model © 2003 South-Western College Publishing

Circular Flow of Income v Because land, labor and capital are generally owned by households, firms must pay for their use v This payment along with profits become income and purchasing power that can be used to buy goods and services v These payments are referred to as resource income 2

Circular Flow of Income v v v The demand for goods and services 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 of income and output in the economy 3

Leakages v Resource income and spending are not always equal because of v. Leakages which flow out of the circular flow that occur when resource income is received and not spent directly on purchases from domestic firms v. Saving v. Taxes v. Import purchases 4

Injections v However, at least some of these leakages are returned to the circular flow via various injections v. Added spending into the circular flow that are not paid out of resource income v. Investment, government spending, and exports bought by foreign buyers 5

Circular Flow - Simple Model Households offer their productive services to businesses in exchange for pay in the form of wages, rent, and interest and owners receive profits Resource Income $$$ Productive Services Businesses Households Income recipients use their money to buy goods and services produced by business Goods and Services $$$ Spending for Goods and Services 6

Stable Economy v If all income is spent vbusiness will sell all goods, and vwill be induced to produce all goods again 7

Stable Economy v. Leakage in the circular flow vsavings v. Injection in the circular flow vinvestment 8

Savings and Investment If planned investment(I) = planned savings(S) so that injections = leakages and total spending = total income and demand = supply then we have a stable economy 9

Contracting Economy v. If leakages exceed injections, we have a contracting economy resulting in vinventory accumulation vtoo little spending vdrop in prices vand. . . Planned I < Planned S 10

Expanding Economy v. If injections are less than leakages, we have an expanding economy resulting in vmore goods and services produced vhigher prices vand. . . Planned I > Planned S 11

Changes in Prices v Whenever leakages exceed injections, it is also possible that the market can be cleared in the price level falls v When injections exceed leakages, increases in the price level will cause the market to clear 12

Equilibrium in the Circular Flow v Equilibrium v. A stable flow of total output and income v. Planned I = planned S injections = leakages v. Price level is stable 13

Equilibrium in the Circular Flow v Planned I < planned S v. Injections < leakages v. Total income and output or the price level tend to decrease v. Income falls, saving decreases until it comes back into balance with investment 14

Equilibrium in the Circular Flow v Planned I > planned S v. Injections > leakages v. Total income and output tend to increase, if the economy is at less than full employment income and saving increase until it comes into balance with investment v. If the economy is at full employment, the price level tends to increase 15

Government & Circular Flow v Balanced budget vamount spent by government = amount collected in taxes v Surplus budget vamount spent by government = less than that collected in taxes v Deficit budget vamount spent by government = more than that collected in taxes 16

International Trade & Circular Flow Imports are a leakage v Exports are an injection v If exports = imports, the circular flow is in balance v Usually it is not balanced v vcalled a trade deficit, because imports (leakages) are greater than exports (injections) 17

Influences on the Circular Flow v Government budget vsurpluses vdeficits v International trade and finance v. Asian financial crisis 18