THE CIRCULAR FLOW OF ECONOMIC ACTIVITY

Circular

Flow- refer to a simple economic model which

describes the reciprocal circulation of income between producers and consumers fundamental representation of macroeconomic activity among the major players in the economy--consumers, producers, government, and the rest of the world. Different versions of the model sequentially combined the four sectors--household, business, government, and foreign--and the three markets--product, resource, and financial--into increasingly more comprehensive representations of the economy.

Basic Economic Activities

Production The use of economic resources in the creation of goods and services for the satisfaction of human wants. Consumption The using up of goods and services by consumer purchasing or in the production of other goods. Employment The use of economic resources in production; engagement in activity Income Generation The production of maximum amount an individual can spend during a period without being any worse off.

Two Economic Units

Primary participants in the circular flow of goods and services Household and Firms
Household
The basic consuming unit.

This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for consumption and undertakes consumption expenditures. It also owns all productive resources.

Firm

The basic producing unit. This includes the institutions (especially proprietorships, partnerships, and corporations-BUSINESS ORGANIZATIONS)

 that

undertake the task of combining resources to produce goods and services. This sector does the production. It also buys capital goods with investment expenditures.

Two Types of Markets in the Circular Flow of Goods and Services

Resource Market is where businesses

purchase what they use to produce goods and services. Resources are in the form of labor, natural resources, capital, and entrepreneurship, all of which are supplied by households.

 Product

markets are where goods and services are sold. Other Sectors involved in the circular flow Government sector: This includes the ruling bodies of the federal,
state, and local governments. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntarily. It buys a portion of domestic product',500,400)">gross domestic product as government purchases.

Foreign sector: This includes everyone and everything (households, businesses, and governments) beyond the boundaries of the domestic economy. It buys exports produced by the domestic economy and produces imports purchased by the domestic economy, which are commonly combined into net exports (exports minus imports).

Stock and Flow Variables

Flow

A quantity measured over a particular period of time. Stock A quantity measured as of a given point in time. The concepts of stock and flow measurements are essential in understanding the economic variables of wealth and income.

Wealth Anything of valued owned. It is a stock since it is what is owned at a particular time. Income The rate at which we earn money. It is a flow since income that is saved, increases the stock of wealth.

Inflows and Outflows

Outflows (factors that decrease the level of economic activity) Savings Taxes Imports Inflows (factors that increase the level of economic activity) Investment Government Spending Exports

Outflows are difficult to control because they are dependent on income. When income increases, we expect savings, taxes, and imports to increase.
Inflows are easier to manipulate. The proper use of policy enables the government to encourage exports and investments and to increase its expenditures when it desires to expand the flow of economic activity.

 Savings-is

setting aside a portion of a persons income for future use Inventory-normal quantity of goods stored by the business firms for future use(stocks)

 Investment-The

sacrifice of current benefits or rewards to pursue an activity with expectations of greater future benefits or rewards. Investment is typically used to mean the purchase of capital by business in anticipation of the profit.

 Taxes-Any

sort of forced or coerced payments to government. The primary reason government collects taxes is to get the revenue needed to finance public goods and pay administrative expenses.

Three Sets of Policy

Monetary policy
Affects the savings and investment.

Fiscal policy
Controls taxes and government expenditures.

Trade policy
Affects a countrys exports and imports.

 Four

Models

The Complete Model

The circular flow model actually consists of four separate models, each sequentially adding sectors or markets and thus providing greater complexity and realism.

1. Two Sectors, Two Markets: The simplest circular

flow model contains two sectors (household and business) and two markets (product and resource). This model highlights the core circular flow of production, income, and consumption.

2.Two Sectors, Three Markets: A second version

of the circular flow model adds the financial markets. This addition illustrates how saving is diverted from the household sector to the business sector to finance investment expenditures.

3. Three Sectors, Three Markets:

A third version

of the model includes the government sector. This model highlights the importance of taxes, which are also diverted from household sector income and used to finance government purchases.

4. Four Sectors, Three Markets: The most

comprehensive circular flow model includes the foreign sector. Adding the foreign sector highlights the role of trade with the rest of the world, especially exports and imports.

The complete circular flow model, with all four macroeconomic sectors (household,
business, government and foreign) and all three macroeconomic markets (product, resource, and financial), is presented in the above exhibit.

Economic Model of Production

The Circular Flow of the Production Process
ECONOMIC RESOURCES

HOUSEHOLDS

PRODUCING UNITS

GOODS AND SERVICES

The Circular Flow of Output and Income

Circular Flow of Physical Goods and Money Income
Goods and Services Factors of Production (land, labor, capital, entrepreneur)

Household Sector

Business Sector

Payments of Factors (rent, wages, interest, profit)

Payment of Purchase of goods and services.

Circular Flow of Goods Among Production Units

RAW
MATERIALS

RAW MATERIAL FIRM

INTERMEDIATE

GOOD FIRM

CONSUMERS
INTERMEDIATE

GOODS FINAL GOODS

FINAL GOOD FIRM

Interrelation Between Production Units & Households

RESOURCES

RAW MATERIAL FIRM

HOUSEHOLDS

RESOURCES

INTERMEDIATE GOOD

FIRM

RESOURCES

FINAL GOOD FIRM

The Circular Flow of Income

INCOME FLOW OF WAGES, INTERESTS, RENTS

HOUSEHOLDS

PRODUCING UNITS( FIRMS)

PURCHASES OF GOODS AND SERVICES

Circular Flow of Income Among Production Units

MONEY PAYMENTS FOR RAW MATERIALS

RAW MATERIALS FIRM MONEY PAYMENTS FOR INTERMEDIATE GOODS

FINAL GOOD FIRM

INTERMEDIATE GOOD

FIRM

MONEY PAYMENTS FOR FINAL GOODS

HOUSEHOLDS

Economic Model of Income and Consumption

The Circular Flow of Goods and Income Among Producers & Households
RESOURCES RAW MATERIAL FIRM

MONEY PAYMENT FOR RERESOURCES

RESOURCES

MONEY PAYMENT FOR RESOURCES

HOUSEHOLDS

INTERMEDIATE GOOD

FIRM

RESOURCES

MONEY PAYMENT FOR RESOURCES

MONEY PAYMENT FOR PURCHASE OF FINAL GOODS

FINAL GOODS

FINAL GOOD FIRM

The Circular Flow of Goods & Income of Households & Firms with the Government & Foreign Countries
GOVERNMENT
Wages, Transfer Payments
Purchase of Goods & Services

Taxes Economic Resources

Taxes

Purchase of Goods & Services

HOUSEHOLDS
PRODUCING UNITS

Income Payments of Wages, Rent, Dividends, & Interests Goods & Services
Money Payments for Imports Money Payments for Exports

FOREIGN COUNTRIES

The Circular Flow of Economic Activity

Reflecting The Outflows & The Inflows
Economic Resources
Purchase of Goods & Services Income Payments of Wages, Rent, Dividends, & Interests

HOUSEHOLDS

PRODUCING UNITS

Goods & Services

IMPORTS Foreign Countries

EXPORTS EXPENDITURES
INVESTMENTS

TAXES

Government

SAVINGS

Banks

Implications of the Circular Flow of Economic Activity

1.

The goods, resources, and money payments will flow as long as households continue to consume, and as long as firms continue to produce. That since goods and resources flow in exchange for payments, the rate of payments flow will in the end be the same. Money is the inducing factor, and the pillar of the price system. Without it, there is no price system.

2.

- THE END -

GOOD DAY!!!