Topic #5: Circular Flow of Transactions in the Economy Dr David Penn Associate Professor of Economics and Director of the Business and Economic Research Center

Circular Flow  Demonstrates the flow of transactions in an economy  Represents interactions of millions of businesses and households  Two kinds of flows are shown:  1) Physical flow of goods, services, and raw materials (clockwise flow)  Inputs to production are termed ‘factors of production’  2) Flow of money (income, revenue, spending, payments) in the other direction (counter-clockwise flow)  The diagram shows two participants (households and businesses) and two markets (the market for goods and services and factor markets)

Circular Flow of Money and Goods & Services Wages, rent, profits, dividends SpendingRevenue Households Businesses Market for goods and services Factor markets Income Factors Goods & services Money flow ($) Physical flow

Circular Flow  Two markets:  Market for goods and services  Factor markets (market for factors of production)  Goods and services produced by businesses are exchanged for money (spending) by households in the market for goods and services.  Factors of production owned by households are exchanged for money (payments) by businesses in the factor market.  Both businesses and households are buyers and sellers.

Problems  Economic fluctuations occur when some of the flows become out of balance  Example 1: What if households suddenly decide to save more of their incomes?  Household income is the sum of spending and saving. If saving suddenly rises, household spending must decline. Less spending in the market for goods and services results in less revenue for businesses. Consequently, businesses spend less for inputs in the factor market, including labor. Unemployment rises and income for households declines. And the drop in household income starts another round of spending cuts.

Problems  Example 2: What if businesses build much more housing than needed by a growing population?  In a housing boom, businesses build more housing in reaction to rising housing spending from households. When housing prices begin to rise rapidly, households begin to purchase housing as an investment, not necessarily to live in. This speculative spending and building cycle, fueled by borrowed money, can create a housing bubble. Eventually, the bubble becomes unsustainable: household demand can’t keep up with housing prices, and the bubble collapses.  Video: China’s housing bubble:

Adding complexity  1) Financial markets  2) Government  3) International sector

Financial markets  Financial markets are a way of channeling the economy’s savings into investments (spending for new physical capital such as structures, machines, equipment). These investments increase the economy’s productive capacity.  The financial market acts as a go-between between lenders (households) and borrowers (businesses).  Flows related to the financial market are shown in blue on the next slide.

Financial markets Business borrowing and stock issuances Households Businesses Market for goods and services Factor marketsFinancial market Saving Investment spending Consumer spending Wages, interest, profit, rent

Government  Government (federal, state, and local) takes in taxes from households and spends on:  1) goods and services (defense, law enforcement, infrastructure, education, transportation) and  2) transfer payments (retirement, income support, medical care, disability).

Government  The government may be a borrower, a lender, or neither.  When tax revenue is less than total government spending, the government must borrow from the financial market.  When tax revenue is greater than total government spending, the government is a source of savings for the financial market.  When tax revenue equals total government spending, the government is neither a borrower nor a lender.  Flows related to the government sector are shown in blue on the next slide.

Financial markets and Government Business borrowing and stock issuances Households Businesses Market for goods and services Factor marketsFinancial market Taxes Investment spending Consumer spending Wages, interest, profit, rent Government Government spending for goods and services Government borrowing Saving Transfer payments

International sector  The international sector consist of  1) trade flows (imports and exports) and  2) international borrowing.  Trade  When households spend for goods made in other countries, we are spending on imports from the rest of the world.  Alternatively, when the rest of the world purchases our goods, we are generating exports.  International borrowing  When our imports are greater than our exports, we must borrow from the rest of the world to pay for the difference.  Alternatively, when our exports are greater than our imports, we are a net international lender.

Financial markets and Government Business borrowing and stock issuances Households Businesses Market for goods and services Factor marketsFinancial market Taxes Investment spending Consumer spending Wages, interest, profit, rent Government Government spending for goods and services Government borrowing Saving Transfer payments Rest of World Foreign lending Foreign borrowing Imports Exports GDP

Summary  The circular flow model is a powerful tool for the showing the interactivity of markets, households, and businesses.  The model allows us to trace the effects when a flow becomes out of balance.