Circular Flow in Economics. The Circular-Flow Diagram Circular Flow in Economics: How households and...
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Transcript of Circular Flow in Economics. The Circular-Flow Diagram Circular Flow in Economics: How households and...
The Circular-Flow DiagramCircular Flow in Economics: How households and businesses interact in the market for resources and in the market for goods and services, and see how money keeps the whole process moving.The circular flow model highlights the “flows” within the economy―the flow of economic resources, goods and services, and the flow of money.
The Circular-Flow Diagram…… is a simple depiction of the macroeconomy.
… illustrates GDP as spending, revenue, factor payments, and income.
First, some preliminaries:Factors of production are inputs like labor,
land, capital, and natural resources. Factor payments are payments to the factors
of production. (e.g., wages, rent)
The Circular-Flow Diagram
Households: own the factors of production,
sell/rent them to firms for income buy and consume Goods &
Services (g&s)
Households: own the factors of production,
sell/rent them to firms for income buy and consume Goods &
Services (g&s)
HouseholdsFirms
The Circular-Flow Diagram
HouseholdsFirms
Firms: buy/hire factors of production,
use them to produce g&s sell Goods & Services (g&s)
Firms: buy/hire factors of production,
use them to produce g&s sell Goods & Services (g&s)
The Circular-Flow Diagram
Markets for Factors of Production
HouseholdsFirms
Income Wages, rent, profit
Factors of production
Labor, land, capital
Spending
G & S bought
G & S sold
RevenueMarkets for Goods & Services
What This Diagram Omits…The government
collects taxespurchases g&s
The financial systemmatches savers’ supply of funds with
borrowers’ demand for loans
The foreign sectortrades g&s, financial assets, and currencies
with the country’s residents
Expanded Circular Flow
Goods
Other countries
Financial markets
GovernmentFirms
(production)HouseholdTaxes
Factor services
SavingsImports
Government
Spending
Wages, rents, interest, profits
Exports
Investment
Personal consumption
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Households earn income via the factor markets from wages, interest on bonds, dividends on stocks, and rent on land.
Via the financial markets, private savings is channeled to firms for investment spending.
Government purchases of goods and services is paid for by tax receipts as well as by government borrowing.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
The expanded circular flow diagram shows the transactions among households, firms, governments, and the rest of the world.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
These transactions take place in factor markets, goods markets, and financial markets.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Households buy consumer goods and services. The red flow, C, shows consumption expenditures.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Households save, S, and pay taxes, T. Firms borrow some of what households save to finance their investment.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Firms buy capital goods from other firms. The red flow I represents this investment expenditure by firms.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than taxes.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
The rest of the world buys goods and services from us, X, and sells us goods and services, M—net exports are X - M
Exports (X) generate an inflow of funds into the country from the rest of the world
Imports (M) lead to an outflow of funds to the rest of the world.
Foreigners can also buy stocks and bonds in the U.S. financial markets.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
The blue and red flows are the circular flow of expenditure and income. The green flows are borrowing and lending.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
The sum of the red flows equals the blue flow.
Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
That is: Y = C + I + G + X - M
SUMMARY: The Circular Flow… Matching Buyers and Sellers
Market for Factors
Market for Goods and Services
FirmsHouseholds
Factor PaymentsIncome
Firm RevenueConsumption
Labor, Land, and Capital for Sale
Labor, Land, and Capital Purchased
Goods and Services for Sale
Goods and Services
Purchased
Businesses provide final goods and services to
households…
…who in turn pay for them with money.
Households “sell” resources to businesses…
…who in turn pay for them with wages, rent, interest, and profits.
SUMMARY: The Circular Flow… Matching Borrowers and Lenders
Market for Factors
Market for Goods and Services
Firms
Households
Financial Markets
Government
Factor PaymentsIncome
Firm RevenueConsumption
Public Savings
Government Spending
Interest
Loans
Private Savings
Taxes
Transfers Transfers
Taxes
Interest
Individuals and governments earn a rate of return from their savings
Businesses can borrow from the bank to obtain capital to purchase inventory