Business Environment 2

Week 2

Circular Flow of Income

1

Learning Objectives

To understand the concepts of circular flow of

income

To bring out the relationship between the four

macroeconomic objectives and the circular

flow of income

To know how aggregate demand affects the

macroeconomic objectives

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Macroeconomics and microeconomics

Macroeconomic theory:

It deals with the aggregate behavior of the

economy as a whole. It studies the problems of

determination of the level of national income,

prices and the rate of interest. It tries to explain

why there are changes in the level of national

income and what accounts for economic growth.

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Macroeconomics and microeconomics

Microeconomic Theory:

The microeconomic theory, on the other hand, deals

with the behavior of individual markets of different

goods and services.

It explains the behavior of household, firm and industry

taking part in the particular markets of a particular

commodity. While explaining such particular markets, it

deals with the question of how the resources are

allocated among different branches of the economy and

how income is distributed among different factors of

production.

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Major Macroeconomic issues

Economic growth: A growing economy means that

there will be more goods and services for people to

consume.

Inflation: By inflation we mean a general rise in

prices throughout the economy.

Unemployment

The balance of payments and exchange rate: The

final issue has to do with the country’s foreign trade

and its economic relationships with other countries.

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Government Macroeconomic Policy

High and stable economic growth

Low unemployment

Low inflation

The avoidance of balance of payments deficits

and excessive exchange rate fluctuations

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Aggregate Demand (AD)

Aggregate Demand (AD) – is the total level

of spending on goods and services in the

economy.

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Aggregate Demand (AD)

Aggregate Demand controls four elements:

Consumer spending on domestically produced goods

and services (Cd),

Investment by firms (I),

Government spending (G), and

The expenditure of foreigners on the subject country’s

export (X); less any expenditure on foreign goods and

services (M).

Therefore, AD = C+I+G+X-M.

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Economic Sectors

The economy is divided into 4 Sectors:

1. Households

2. Firms

3. Government

4. Foreign sector

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1. Households

Households: Households consist of consumers.

They provide the factors of production, or

resources used in production.

What are the factors of production? (Land, labour & capital)

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2. Firms

Firms: This sector consists of the

organizations (companies) that produce goods

and services

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3. Government

Government: It is also known as the public

sector. It consists of the economic activities of

government.

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4. Foreign Sector

Foreign Sector:

This comprises the economic activities of

people outside the domestic economy

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Circular Flow of Income

How to analyze the interaction of the 4

economic sectors?

The usual way of analyzing the interaction of these

sectors is a model known as the circular flow of income

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Circular Flow of Income

The modern economy is a monetary economy. In the

modern economy, money is used in the process of

exchange. Money has facilitated the process of exchange

and has removed the difficulties of the barter system. Thus,

money acts as a medium of exchange.

The households supply the economic resources or factors

to the productive firms and receive in return the payments

in terms of money. It is thus clear that, in the monetary

economy, there will be flows of money corresponding to the

flows of economic resources and the flows of goods and

services. But each money flow is in opposite direction to the

real flow.

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Circular Income Flow in a Two Sectors Economy

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Fig.2.1

Circular Income Flow in a Two Sectors Economy

In Fig…….., in the upper loop of this figure, the resources such

as land, capital and entrepreneurial ability flow from households

to business firms as indicated by the arrow mark. In opposite

direction to this, money flows from business firms to the

households as factor payments such as wages, rent, interest and

profits.

In the lower part of the figure, money flows from households to

firms as consumption expenditure made by the households on

the goods and services produced by the firms, while the flow of

goods and services is in opposite direction from business firms to

households. Thus there is, in fact, a circular flow of money or

income.

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Circular Flow of Income

Factor

payments

Consumption of

domestically

produced goods

and services (Cd)

WITHDRAWALSWITHDRAWALS

INJECTIONSINJECTIONS

The circular flow of incomeThe circular flow of income

BANKS, etc GOV. ABROAD

Investment (I)

Government

expenditure (G)

Export

expenditure (X)

Net

saving (S)

Net

taxes (T)

Import

expenditure (M)

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Fig.2.2

Circular Flow of Income

On the left side, the firms pay to household money in terms of

wages, salaries, and dividends from investments, interest, and

rent. These are payments for factors of production (e.g. labour, capital, and land) which are supplied by the households. Money

flows from firms to households as factor payments.

On the right side, households pay money to firms as payment for

domestically produced products and services consumed by

households.

Granting that households spend all their income and firms pay all

its income they received from consumers; and if the speed at

which the money circulates does not change, the movement will continue indefinitely unchanged in the inner flow.

However, this does not happen in reality because there

withdrawals and injections as indicated in the diagram.

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Withdrawals & Injections

Withdrawals (W) – are incomes of households

which do not pass through the inner flow (e.g. net

savings [S], net taxes [T], export expenditures [M]).

Thus, W=S+T+M

Injections (J) – are expenditures on the

production of domestic firms coming from outside

the inner flow (e.g. investments [I], government

expenditures [G], export expenditures [X]).

Thus, J=I+G+X

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The components of withdrawals

The households spend only part of the income

received on the goods and services of domestic

firms. The rest of the income will be withdrawn

from the inner flow. There are 3 forms of

withdrawals:

1. Net Savings (S)

2. Net Taxes (T)

3. Import expenditure (M)

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The components of Injections

Only part of the demand for firms output arises

from consumer expenditure. The rest comes from

other sources outside the inner flow. These

additional components of aggregate demand are

known as injections. They are:

1. Investment (I)

2. Government Expenditure (G)

3. Export Expenditure (X)

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GDP (Total Output)

Y = C + I + G + X – M

Y = Expenditure

C = Total consumer expenditure (spending)

I = Investment

G = Government expenditure

X = Exports

M = Imports

X – M = Net exports

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Circular flow and the 4 Macroeconomic Objectives

What are the effects of aggregate demand on the four macroeconomic objectives:

There will be economic growth. The greater the initial excess of injections over withdrawals, the bigger will be the rise in national income;

Unemployment will fall as firms take on more workers

to meet the extra demand for output; more people will be employed by the firms in order to meet aggregate demand.

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Effects of Aggregate Demand

Inflation tend to rise. The greater the rise in aggregate

demand relative to the capacity of firms to produce, the more firms will find it difficult to meet the extra demand, and the more likely they will raise prices.

Exports and imports as part of the balance of

payments will tend to deteriorate. The high demand

will invite more imports, and high domestic inflation will make exports less competitive, and domestic products will be more expensive than imported. As a result, import will tend to rise as export will tend to fall. Equals balance of payment deficit.

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Injections > Withdrawals

The ideal is Injections = Withdrawals

But, what happens to the four objectives if planned

injections exceed planned withdrawals?

– national income will rise

– unemployment will fall

– inflation will rise

– imports will rise

– export will fall

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Injections < Withdrawals

What happens if planned injections are less

than the planned withdrawals?

– National income will fall.

– Unemployment will rise.

– Inflation will fall.

– Imports will fall.

– Export will rise.

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