Circular Flow of Income and Business Cycles

Circular Flow of Income

  • The circular flow of income illustrates the connections between five sectors of an economy:
    1. Consumers
    2. Businesses
    3. Financial institutions
    4. The government
    5. The overseas sector
  • It depicts injections and leakages within the economy, which help economists assess changes in economic activity.

2 Sector Model

  • Demonstrates the movement of money between households and firms.
  • Households purchase goods/services from firms (consumption).
  • Firms employ households to produce goods/services (income).
  • Households work for firms to earn income, which is then used to buy goods/services from the firms.
  • Consumers and businesses are interdependent.
    • Businesses need consumers to buy their products.
    • Consumers rely on businesses for both goods/services and income.

3rd Sector - Finance

  • Financial sector acts as intermediaries between savers and borrowers (e.g., banks).
  • Financial institutions receive savings and lend money to borrowers.
  • Saving is a leakage from the circular flow of income.
  • Investment, where money is borrowed to expand a business, is an injection into the circular flow.
  • In the 2-sector model, money is spent through consumption and employment.
  • With finance, consumers can choose to save, and firms can choose to invest.
  • Saving = leakage.
  • Investment = injection.

4th Sector - Government

  • Includes local, state, and federal governments.
  • Significant roles:
    1. Taxation (leakage): Government collects taxes from individuals and businesses.
    2. Government expenditure (injection): Government spends money on infrastructure, welfare, education, and health.

5th Sector - Overseas

  • Trade impacts an economy through exports and imports.
  • Exports (injections): Australian businesses sell goods/services overseas.
  • Imports (leakages): Australians buy overseas goods/services.

Leakages and Injections

  • Used to measure changes in the level of economic activity.
  • Injections > Leakages = Economic growth and expansion.
  • Leakages > Injections = Economic decline.
  • The government's role is to manage the economy by altering money flows.
  • Equilibrium: Leakages=InjectionsLeakages = Injections
  • Economic Decline: Leakages > Injections
  • Economic Growth: Injections > Leakages
  • Leakages=Savings+Taxation+ImportsLeakages = Savings + Taxation + Imports
  • Injections=Investment+Government spending+ExportsInjections = Investment + Government \,spending + Exports
  • C=ConsumptionC = Consumption
  • Y=IncomeY = Income

The Business Cycle

  • The business cycle represents fluctuations in economic activity.
  • Features of the Business Cycle:
    • Boom: Peak economic activity.
    • Contraction: Economic decline.
    • Trough: Lowest point in the economic cycle.
    • Recession: Continuously low economic activity (two successive quarters of negative economic growth).
    • Expansion: Increased economic activity.

Characteristics of Contraction:

  • Falling production levels.
  • Decreasing consumer spending.
  • Inflation rate may fall.
  • Wage rates generally fall.
  • Interest rates eventually fall.
  • Unemployment level rises.

Characteristics of Expansion:

  • Rising production levels.
  • Increasing consumer spending.
  • Inflation rate may rise.
  • Wage rates generally rise.
  • Interest rates eventually rise.
  • Unemployment level falls.

Business Cycle Fluctuations

  • The business cycle doesn't follow a regular pattern.
  • Expansion periods can last from months to years.
  • Contraction doesn't always lead to recession if recovery occurs quickly.
  • Example: RBA lowering interest rates to encourage spending and avoid recession.
  • A downturn in one production area can spread due to the economy's interdependent nature.

Recessions

  • Caused by a lack of spending.
  • Reduced spending signals businesses to cut back production.
  • Job losses and reduced incomes lead to further declines in spending.
  • Widespread and long-lasting recession = depression.

Features of a Recession:

  • Income and production at lowest levels.
  • Increased business closures.
  • High unemployment levels.
  • Low inflation rate.
  • Falling or slow-growing wages and salaries.
  • Lowest consumer demand, sales, and profits.
  • Numerous bankruptcies.
  • Unused resources and no incentive to purchase new machinery.
  • Reduced borrowing.
  • Low interest rates.

Booms

  • Characterized by growth and prosperity; rising production, spending, and employment.
  • Businesses expand, employees are hired, and incomes increase.
  • High consumer and business confidence.

Key Features of a Boom:

  • Low unemployment levels.
  • High income and production levels.
  • High wages and salaries.
  • Businesses operating at full capacity.
  • Increased consumer demand leads to price increases rather than increased production.
  • High interest rates.
  • Inflation rate rises sharply.

Inflation

  • Continuously high economic growth can lead to inflation (general increase in the cost of goods and services).

The Price Mechanism

  • Price is determined by supply and demand, which addresses scarcity.

Demand

  • Demand is the quantity of a product consumers are willing to purchase at a particular price at a given time.
  • Law of Demand: As prices increase, demand decreases, and vice versa.

Supply

  • Supply is the quantity of a good or service businesses are willing to produce at a given price and time.
  • Law of Supply: As prices increase, the quantity supplied increases, and vice versa.

Market Equilibrium

  • The intersection of supply and demand curves is called market equilibrium.
  • At this point, quantity produced equals quantity demanded.
  • The price mechanism is the force of supply and demand determining price and quantity.

Changes in Demand

  • Factors other than price cause shifts in the entire demand curve, changing equilibrium price and quantity.
  • Increase in demand: Demand curve shifts right; price and quantity increase.
  • Decrease in demand: Demand curve shifts left; price and quantity decrease.

Factors Causing Increase/Decrease in Demand

  • Changes in consumer tastes and preferences.
  • Changes in population size.
  • Substitute goods price change.
  • Complementary goods price change.
  • Expected future price change.

Increase/Decrease in Supply

  • Factors other than price that shift the entire supply curve.
  • Increase in supply: Supply curve shifts right, price decreases, quantity increases.
  • Decrease in supply: Supply curve shifts left, price increases, quantity decreases.

Factors Increasing/Decreasing Supply

  • Efficiency.
  • Cost of production.
  • Climatic conditions.
  • Number of suppliers.

Types of Markets

  • A market is where buyers and sellers exchange goods or services (physical or non-physical).

Main Types of Markets:

  1. Retail Markets
  2. Labor Markets
  3. Financial Markets
  4. Stock Markets

Retail Markets

  • Allow the buying of goods and services (shopping centers, strips, online).
  • Online shopping has increased significantly in recent years.

Labor Markets

  • Involves communication between businesses and potential employees (online advertising, newspapers, etc.).
  • Employers (buyers) seek skills and effort from employees (sellers).
  • The price paid for labor is wages or salaries.

Financial Markets

  • Intermediaries between savers and borrowers.
  • Households and businesses deposit or borrow money.
  • Interest is the price of having access to money belonging to others.
  • Banks pay interest on savings and charge higher interest to borrowers to make a profit.

Stock Market

  • Involves buying and selling shares in public companies.
  • A share is a unit of ownership in a company.
  • Share value can fluctuate based on demand.
  • Buyers = Investors.
  • Sellers = Businesses AND other investors.
  • More buyers than sellers: price rises.
  • More sellers than buyers: price falls.

Government Intervention

  • A free market allocates resources efficiently but can lead to negative outcomes.
  • Governments intervene to reduce problems (environmental degradation).

Environmental Degradation

  • Preventing environmental degradation is both an environmental and economic issue.
  • Governments can impose regulations to restrict activities that cause environmental damage (littering bans, chemical use control, building restrictions).

Conservation of Natural Resources

  • Natural resources need to be conserved for future generations.
  • Governments face trade-offs between short-term exploitation and long-term needs.
  • Sustainable management of the environment is needed for long-term economic growth.

Types of Businesses

  1. Online
  2. On-Demand
  3. Small and Large
  4. Global
  5. Offshore
  6. Government
  7. Not-for-Profit

Online Business

  • Some or all of a business is conducted using the internet.
  • Offers opportunities for entrepreneurship without costs of physical store.

On-Demand Business

  • Uses mobile technology (apps/websites) to maximize consumer convenience.
  • Offers deliveries, order ahead, etc.

Small and Large Businesses

  • Micro business: fewer than 5 employees.
  • Small businesses: 5-20 employees.
  • Medium business: 20-199 employees.
  • Large business: 200 or more employees.
  • 98% of Australian businesses are SMEs, employing about 7 million people.

Global Businesses

  • Large companies with branches in many different countries (Transnational Corporations - TNCs).

Offshore Business

  • Functions are completed in different countries to take advantage of cheaper production costs.
  • Can lead to unethical practices like sweatshops.

Government Business

  • Government owned and operated providing essential community services.
  • Examples: Australia Post, NBN Co, Sydney Water, Sydney Trains.

Not-For-Profit Organizations

  • Provide services to the community and do not earn a profit for owners.
  • Money earned goes back into services provided., tax concessions.
  • Examples: charities, community service organizations, cultural societies.

Factors Influencing Business Decisions

  1. Technology
  2. The Business Cycle
  3. Globalization

Technology

  • Leads to increased efficiency, productivity, and new product development.
  • Robotics and automation improve manufacturing and reduce costs.
  • IT advancements improve communication.
  • Enables flexible work arrangements.

The Business Cycle

  • Businesses are affected by economic ups and downs.
  • Economic downturns reduce consumer spending.
  • Economic growth increases consumer spending.
  • Consumer confidence drives spending and performance.
  • Businesses selling consumer or luxury goods are most affected.

Globalization

  • Involves reducing barriers to trade, investment, and labor across borders.
  • Creates new opportunities but increases competition.
Positives:
  • Expanded markets.
  • Cheaper materials (global sourcing).
  • Access to labor.
Negatives:
  • Increased competition.
  • Increased unemployment in some industries.
  • Environmental and social issues.

Ethics and Corporate Social Responsibility

  • Corporate Social Responsibility (CSR) is where businesses consider the impact of their decisions on society and environment.
  • Characterized by ethical decision-making and going above legal requirements.
  • Values profits, social responsibility, and environmental sustainability.
  • Can attract and retain customers, improve reputation and foster trust in the long term.