Circular Flow Gemma Kotula Christopher Newport University Center for Economic Education

Lets look at some definitions Market – any place where buyers and sellers come together Revenue – money earned from the sale of goods & services Interest – additional money owed when taking out a loan Wages – money paid for labor (workers) Income – money earned by performing labor (working) Rent – money paid for the use of land or property

Businesses Households Circular Flow Decision Makers

2 Markets Circular Flow Product Market Businesses Resource Market Market for Goods & Services Businesses Households Circular Flow 2 Decision Makers 2 Markets Resource Market (Factor Market) Market for Factors of Production

Circular Flow Product Market Businesses Resource Market Households Market for Goods & Services Spending $ Goods and Services Bought by Consumers Businesses Households Circular Flow Flow of Dollars Flow of Goods and Services Resource Market (Factor Market) Market for Factors of Production

Circular Flow Product Market Businesses Resource Market Households $ $ Market for Goods & Services Revenue Spending $ $ Goods and Services Bought by Consumers Goods and Services Sold By Firms Businesses Circular Flow Households Flow of Dollars Flow of Goods and Services Resource Market (Factor Market) Market for Factors of Production

Circular Flow Product Market Businesses Resource Market Households $ $ Market for Goods & Services Revenue Spending $ $ Goods and Services Sold By Firms Goods and Services Bought by Consumers Businesses Circular Flow Households Decision Makers Markets Flow of Dollars Land, Labor, Capital, Entrepreneurship and Technology Flow of Goods and Services $ Flow of Factors of Production Resource Market (Factor Market) Market for Factors of Production Wages, Rents, and Interest

Circular Flow Product Market Businesses Resource Market Households $ $ Market for Goods & Services Revenue Spending $ $ Goods and Services Sold By Firms Goods and Services Bought by Consumers Businesses Households Circular Flow Decision Makers Markets Flow of Dollars Land, Labor, Capital, Entrepreneurship and Technology Land, Labor, Capital, Entrepreneurship and Technology Flow of Goods and Services $ Flow of Factors of Production $ Resource Market (Factor Market) Market for Factors of Production Income Wages, Rents, and Interest

Circular Flow of Dollars Even though we have worked quadrant to quadrant we now have a complete… Circular Flow of Dollars

Flow of Dollars Circular Flow Product Market Businesses Revenue Spending Product Market Market for Goods & Services $ $ Decision Makers Markets Circular Flow Businesses Households Flow of Dollars $ $ Resource Market (Factor Market) Market for Factors of Production Wages, Rents, and Interest Income

and the Factors of Production Even though we have worked quadrant to quadrant we now have a complete… Circular Flow of Goods, Services, and the Factors of Production

Circular Flow Product Market Businesses Resource Market Households Market for Goods & Services Goods and Services Bought By Consumers Goods and Services Sold By Firms Circular Flow Businesses Decision Makers Markets Households Flow of Goods and Services & Flow of Factors of Production Land, Labor, Capital, Entrepreneurship & Technology Land, Labor, Capital, Entrepreneurship & Technology Resource Market (Factor Market) Market for Factors of Production

Putting all flows together shows us that they are indeed circular. Therefore the dollars that flow around counterclockwise (in this example) are equal to… The goods, services, and factors of production that flow around clockwise (in this example).

Flow of Goods and Services & Flow of Factors of Production Revenue Spending Product Market Market for Goods & Services $ $ Goods and Services Bought By Consumers Goods and Services Sold By Firms Circular Flow Decision Makers Markets Flow of Dollars Flow of Goods and Services & Flow of Factors of Production Businesses Households Land, Labor, Capital, Entrepreneurship & Technology Land, Labor, Capital, Entrepreneurship & Technology $ $ Resource Market (Factor Market) Market for Factors of Production Wages, Rents, and Interest Income

Does the Circular Flow Leak? Classical economists were guided by Say’s Law. In a simple economy Say’s Law states that by producing goods and services, firms create a total demand for goods and services equal to what they have produced. Or more simply, supply creates its own demand. So yes there may be leaks!

But it also gets “pumped up”! Households don’t spend all of their income. Rather, some of their income goes to savings (leakage) or to pay taxes (leakage). Households are not the only spenders in the economy. Rather, firms also spend money on capital goods (injection) and the government also spends money on final goods and services (injection). In addition to markets for goods and markets for resources, there is also a loanable funds market where household saving is made available to firms and the government.

Total spending in the circular flow will equal total output in the circular flow if and only if leakages in the economy are equal to total injections.

Or… what goes around comes around! Total Spending = Total Output Or… what goes around comes around!

Government has a role in the economy… However, the government’s role in the economy is dependent on the taxes it charges (and firms and households pay). And that role includes providing goods and services to those same firms and housholds!

Product Market Businesses Resource Market Households Market for Revenue Spending Product Market Market for Goods & Services $ $ Government Provides goods and services to Households and receives taxes in return Businesses Households Government Provides goods and services to Firms and receives taxes in return $ $ Resource Market (Factor Market) Market for Factors of Production Wages, Rents, and Interest Income