1.3 - The circular flow of income model Flashcards
Closed Economy
Closed economy - No links with the other countries (it is closed to international trade), and is also a model of an economy with no government and no banks or financial market.
Four factors of production
- Land
- Labour
- Capital
- Entrepreneurship
Counterclockwise Direction
Flow of money used as payment in sales & purchases. When households sell their factors of production to firms, they receive payments taking the form of rent (for land), wages (for labour), interest (for capital) and profit (for entrepenreurship).
The payments that households make to buy goods and services are household expenditures for consumer spending.
The payments that firms make to buy factors of production represent their costs of production and the payments they receive by selling goods and services are their revenues.
Income Flow
Money that goes from firms to households is equal to the expenditure flow from households to firms which is the money that households spend to buy things from firms.
In other words, the household incomes coming from the sale of all factors of production equals the expenditure by households on goods and services. This is circular flow of income.
Output flow
In addition these 2 flows must be equal to the value of goods and services, or the value of total output produced by the firms known as output flow.
If each good and service is multiplied by its respective price, we obtain the value of each good and service, and adding them all up we arrive at the value of total output. This value is the same as consumer expenditure, since spending by consumers is equal to each item then they buy multiplied by its price.
CIRCULAR FLOW OF INCOME DEFINITION
The circular Flow of income shows that in any given time period, the value of output produced in an economy is equal to the total income generated in producing that output, which is equal to the expenditures made to purchase that output.
Adding leakages & injections
Pairs of leakages and injections
SAVING - INVESTMENT
TAXES - GOVERNMENT SPENDING
IMPORTS - EXPORTS
Savings and investment
Saving leaks out of the flow of consumer expenditure and after passing through financial markets is injected back into the expenditure flow as investment
Saving is a part of consumer income that is not spent but rather is saved. Investment is spending by firms for production of capital goods, which is one of the four factors of production. This is why capital goods are also known as investment goods.
When households save income, this represents leakage because it is income that is not spent to buy goods and services. Households place their savings in financial markets.
Firms obtain funds from financial markets to finance investment, or the production of capital goods. These funds therefroe flow back into the expenditure flow as injections.
Taxes and Government Spending
Households pay taxes to the government; this is a leakage because income that is not spent to buy goods and services. The government uses tax funds to finance government expenditures and this spending Is an injection back into the expenditure flow.
Imports and Exports
Imports are goods and services produced in other countries and purchased by domestic buyers. Exports are goods and services produced domestically and purchased by international buyers.
Imports signify a leakage as household spending leaks out as payments to other countries that produced the goods and services. Exports are an injection because they are spending by foreigners who buy goods and services produced by domestic firms.
Exports are an injection because they are spending by foreigners who buy goods and services produced by domestic firms
Size of circular flow
Leakages>injections - Smaller
Injections>leakages - larger
If leakage greater than an injection, then the size of circular flow becomes smaller. The result is that fewer goods and services are purchased. Firms cut back on their output, they buy fewer factors of production, unemployment increases and household income is reduced.
If a leakage Is smaller than injection. Unemployment falls, household income increases.
