Chapter 8

The Circular Flow Model

© 2003 South-Western College Publishing

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Circular Flow of Income Because land, labor and capital are

generally owned by households, firms must pay for their use

This payment along with profits become income and purchasing power that can be used to buy goods and services

These payments are referred to as resource income

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Circular Flow of Income

The demand for goods and services 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 of income and output in the economy

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Leakages

Resource income and spending are not always equal because ofLeakages which flow out of the circular flow

that occur when resource income is received and not spent directly on purchases from domestic firms

SavingTaxesImport purchases

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Injections

However, at least some of these leakages are returned to the circular flow via various injectionsAdded spending into the circular flow that

are not paid out of resource incomeInvestment, government spending, and

exports bought by foreign buyers

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Circular Flow - Simple Model

BusinessesBusinesses HouseholdsHouseholds

Goods and Services

Productive Services

Spending for Goods and Services

Resource Income

$$$$$$

$$$$$$

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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Stable Economy

If all income is spent

business will sell all goods, and

will be induced to produce all goods again

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Stable Economy

Leakage in the circular flowsavings

Injection in the circular flowinvestment

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Savings and Investment

If planned investment(I) = planned savings(S)

so that injections = leakagesand total spending = total income

and demand = supplythen we have a stable economywe have a stable economy

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Contracting Economy

If leakages exceed injections, we have a contracting economy resulting ininventory accumulationtoo little spendingdrop in pricesand...Planned I < Planned S

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Expanding Economy

If injections are less than leakages, we have an expanding economy resulting inmore goods and services producedhigher prices

and... Planned I > Planned S

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Changes in Prices

Whenever leakages exceed injections, it is also possible that the market can be cleared in the price level falls

When injections exceed leakages, increases in the price level will cause the market to clear

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Equilibrium in the Circular Flow

EquilibriumA stable flow of total output and

incomePlanned I = planned S injections =

leakagesPrice level is stable

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Equilibrium in the Circular Flow

Planned I < planned S

Injections < leakagesTotal income and output or the price level tend to

decreaseIncome 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 > leakagesTotal income and output tend to increase, if the

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 budgetamount spent by government = less than that

collected in taxes Deficit budgetDeficit budget

amount spent by government = more than that collected in taxes

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International Trade & Circular Flow ImportsImports are a leakage ExportsExports are an injection If exports = 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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Influences on the Circular Flow

Government budgetsurpluses

deficits International trade and finance

Asian financial crisis