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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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Equilibrium in the Circular Flow
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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Equilibrium in the Circular Flow
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