The Circular Flow of Income

The circular flow of income Here is what you should already know: the circular flow of ALL markets is characterized by the interdependence of goods markets and factor markets

FIRMS (suppliers of goods and services, demanders of factor services) HOUSEHOLDS (demanders of goods and services, suppliers of factor services) The interdependence of goods and factor markets

Q1Q1 P1P1 QF2QF2 PF2PF2 Q2Q2 P2P2 PF1PF1 QF1QF1 D2D2 D2D2 P Q P Q$ $ $$ Factor services Goods Factor services S S D1D1 D1D1 (1) Consumer demand (1) Consumer demand (4) Factor supply (4) Factor supply (3) Factor demand (3) Factor demand (2) Producer supply (2) Producer supply O O

The circular flow of income Here is what you don’t know about the circular flow, but now NEED TO KNOW: the circular flow of income is also characterized by consumption, injections, withdrawals, and equilibrium

Factor payments Factor payments Consumption of domestically produced goods and services (C d ) Consumption of domestically produced goods and services (C d ) The circular flow of income Firms Households

Factor payments Consumption of domestically produced goods and services (C d ) Investment (I) Government expenditure (G) Government Export expenditure (X) Export BANKS, etc Net saving (S) Net saving (S) GOV. Net taxes (T) Net ABROAD Import expenditure (M) Import The circular flow of income WITHDRAWALS INJECTIONS

The circular flow of income: withdrawals or “leakages” Withdrawals are sometimes called “leakages” and they are expenditures that are temporarily “withdrawn” from the circular flow of national income. Households do not always spend everything they earn; they are often able to save a portion of their earnings. This is called “savings” and it represents a type of withdrawal. Government taxes households. From the Household’s point of view, the money “spent” in paying taxes is money that they cannot use to consume, so taxes, too, are a form of withdrawal. When Households consume, they do not always purchase domestically produced goods and services; sometimes they buy imports. Ultimately the money they spend on imports “leaks out” or is withdrawn from the national circular flow.

The circular flow of income: “injections” Injections happen when the money that Households temporarily took out of the circular flow is “injected” back into the national economy. Banks take Household savings and offer it to firms in the form of loans. When firms take out loans in order to expand their production or to make their production more efficient, we call this, “investment.” Banks are a major source of investment capital. Government takes the revenue that consumers pay in taxes and they spend it on public goods and services. Government also spends tax revenue on spending that we call “transfer payments.” These are payments to individuals that are not made in exchange for labor, but rather payments to individuals because the individuals have some kind of need. Payments made to veterans, impoverished people, or disabled people all represent forms of transfer payments. People in other nations purchase goods produced here in our domestic economy; in other words, they buy U.S. imports. The revenue they spend ends up coming in to our domestic economy, and we call that an “injection.”

The circular flow of income: note on terminology When households save more than they spend, we simply refer to the result as savings. When households spend more than they save, we call the result dis-savings or indebtedness. When the amount of government spending is greater than the amount of tax revenue, there is a deficit (sometimes called a fiscal deficit). If deficits build up, year upon year, we call the result the national debt. When the amount of government spending is less than the amount of tax revenue, there is a surplus (sometimes called a fiscal surplus). When the value of a nation’s imports exceeds the value of its exports, we say that there is a trade deficit, and money is flowing out of the national economy. When the value of a nation’s imports is less than the value of its exports, then there is a trade surplus, and money is flowing into the national economy.

The circular flow of income: final note on “leakages” and “injections” In order for the circular flow to be in complete equilibrium, leakages would have to equal injections and in a perfect world, they would. We do not live in a perfect world! In reality, national economies all suffer from various states of disequilibrium with respect to savings & investments, government spending & taxation, and imports versus exports. Short-run disequilibria are common, normal aspects of a functioning, national economy. Long-run disequilibria, which we shall discuss later, cause problems.