Circular Flow of Income Notes

Circular Flow of Income

Two-Sector Model (Households and Firms)

• Basic Model: Firms hire factors of production (labor, land, capital, and entrepreneurship) from households to produce goods and services.
• Households receive rent, wages, interest, and profit in return for their services.
• Circular Flow:
  • Households earn income, which they use to buy goods and services from firms.
  • Firms use the revenue to pay for factors of production.
  • This creates a continuous flow of money and resources between households and firms.

Equilibrium in the Two-Sector Model

• Definition: An economy is in equilibrium when all factor payments are spent on domestically produced goods and services.
• Example: If firms pay £10 million in factor payments, households spend £10 million on goods and services.

Disequilibrium

• Reality: Households typically do not spend all their income, and firms do not spend all their revenue on hiring labor.

Household Saving

• Households save a portion of their income, reducing the amount spent on goods and services.
• This leads to a contraction of the economy.
• Equilibrium can be restored through reduced factor payments (lower wages, decreased production, or unemployment).
• Example: If households save £1 million, national income/output/expenditure decreases to £9 million.

Firms Retaining Profit

• Firms retain profits for future investments, reducing factor payments.
• This also leads to a contraction of the economy.
• Equilibrium may be restored by households spending less due to reduced wages, production cuts, or unemployment.
• Example: If firms retain £1 million, national income/output/expenditure decreases to £9 million.

Injections into the Circular Flow

• Definition: Money that enters the circular flow from an external source.
• Example: Firms invest retained profits or borrowed funds.
• Effect: Injections increase national income, output, and expenditure.

Investment Spending

• An increase in factor payments due to investment leads to economic expansion.
• Equilibrium may be restored by households increasing spending on goods and services (through increased wages, production, or employment).
• Example: If investment increases factor payments by £1 million, national income/output/expenditure increases to £11 million.

Three-Sector Model (Government Added)

• Includes government expenditure and taxation.

Government Spending (G)

• Injection: Government spending is an injection because it doesn't originate from household spending.
• Benefits:
  • Households: Employment in the public sector, higher wages, transfer payments.
  • Firms: Winning contracts, grants, and subsidies.

Net Tax Payments

• Taxes paid by households and firms represent a withdrawal from the circular flow.

Equilibrium in the Three-Sector Model

• Condition: Planned injections = Planned withdrawals
  • $I + G = S + T$
• If planned injections are greater than planned withdrawals, the circular flow expands.

Four-Sector Model (Open Economy: Exports & Imports)

• Includes exports and imports.

Imports (M)

• Withdrawal/Leakage: Money leaving the circular flow when households purchase goods and services from foreign firms.
• S + T + M

Exports (X)

• Injection: Money entering the circular flow from foreign countries purchasing domestically produced goods and services.
• Effect: Increases national income.
• G + X

Equilibrium in the Four-Sector Model

• Condition: Planned injections = Planned withdrawals
  • $I + G + X = S + T + M$

Disequilibrium and National Income

• Disequilibrium Conditions:
  • Planned injections > Planned withdrawals: I + G + X > S + T + M (Expansionary effect, increased national income)
  • Planned injections < Planned withdrawals: I + G + X < S + T + M (Contractionary effect, reduced national income)

Summary: The Four-Sector Model

• A model describing the reciprocal circulation of income between producers and consumers in an open economy.
• Injections: I (Investment) + G (Government Spending) + X (Exports)
• Withdrawals: S (Savings) + T (Taxes) + M (Imports)