THE CIRCULAR FLOW OF INCOME

Refers to a simple economic model which describes the reciprocalCIRCULAR FLOW OFcirculation of income between producers and consumers.

INCOME

In any economy there are 2 main entities, households and firms. These are linked in severalimportant ways.

Households purchase the output of firms which is called CONSUMPTION.

In return they receive the goods and services that the firms produce known asOUTPUT.

However, no production could take place at all unless households also supplied firmswith the four FACTORS OF PRODUCTION.

In return households receive FACTOR INCOME for the factors of production theysupply.

In a closed system such as the one above every single penny that is spent by households willreturn to households in the form of factor incomes. Firms and Households’ decisions generatespending, output and income and these are the three ways of measuring total economic activity.Indeed because of the fact that in this version of the circular flow of income the following mustbe true:

NATIONAL EXPENDITURE = NATIONAL INCOME = NATIONAL OUTPUT(National Income Identity)

C=Y=Q

-1-

THE FINANCIAL SECTOR - SAVING & INVESTMENT

Refers to a leakage from the circular flow of income into the financial

SAVING sector of the economy.

Our model as it currently stands is unrealistic as it makes the assumption that households spendall of their income. In reality of course households will save a proportion of their income. Savingis therefore regarded as a leakage from the model.

The more households save of their income the less they will spend on consumption.

↓Firms will therefore find that some of their output is going unsold.

↓They will respond by cutting output and making workers (and other factors of production)

redundant.

↓There will be a fall in national income, output and employment as a result.

↓If households continue to save a proportion of their income, national income, output and

employment will eventually fall to zero.

Fortunately there is an offsetting expenditure, in the form of investment. This is expenditure byfirms on capital equipment, in order to increase productive capacity and income in future periodsof time. It has the opposite effect that saving has on the model, i.e. a rise in national income,output and employment.

An injection into the circular flow of income in the form of

INVESTMENT expenditure by firms on capital equipment.

-2-

Investment leads to additional demand for the output of firms in the purchasing of the items ofcapital equipment.

↓Firms will therefore find that there is an output shortage; they are not creating enough output.

↓They will respond by increasing output and employing a greater number of workers (and other

factors of production).

↓There will be a rise in national income, output and employment as a result.

SAVING – a leakage from the circular flow of income, if S > I then will lead to a fall in income,output and employment. This is a DEFLATIONARY situation.

INVESTMENT – an injection into the circular flow of income, if I > S then will lead to anincrease in income, output and employment. This is an INFLATIONARY situation.

MONETARY POLICY (Demand-side policy)

The level of saving and investment in the economy is very much affected by the interest rate inthe economy at the time, so we must look at Monetary Policy at this stage. This is controlled bythe Bank of England (Monetary Policy Committee).

The use of interest rates (r) and the money supply to control the

MONETARY POLICY economy.

Expansionary Monetary Policy – This is where the interest rate is cut and or the moneysupply increased.Contractionary Monetary Policy – This is where the interest rate is raised and or themoney supply decreased.

EXPANSIONARY MONETARY POLICY

There is less incentive to save as rewards are less, saving falls and therefore consumptionrises. S↓→ C↑It is also cheaper to borrow as the monthly interest payments on any loan will be less,

therefore borrowing increases and thus consumption rises. Borrowing↑→ C↑Monthly interest payments will fall on mortgages, therefore any home owners withoutstanding mortgages will have more money to spend thus consumption increases.

Disposable Income↑→ C↑If consumption is rising following a cut in interest rates, firms will want to increaseproductive capacity in order to meet the increased demand for their products, thus

investment increases. C↑→ Q↑→ I↑It is cheaper to borrow money for investment purposes (much investment is financed

through borrowing) thus investment increases. Cost of Borrowing↓→ I↑If the interest rate falls, there will be more investment projects which yield a rate ofreturn greater than the rate of interest that could be earned from banks, therefore moreinvestment projects will be undertaken, thus investment rises.

Comparative Returns↑→ I↑

-3-

CONTRACTIONARY MONETARY POLICY

There is more incentive to save as rewards are greater, saving rises and thereforeconsumption falls. S↑→ C↓It is also more expensive to borrow as the monthly interest payments on any loan will be

more, therefore borrowing decreases and thus consumption rises. Borrowing↓→ C↓Monthly interest payments increase on mortgages, therefore any home owners withoutstanding mortgages will have less money to spend thus consumption decreases.

Disposable Income↓→ C↓If consumption is falling following a rise in interest rates, firms will want to decreaseproductive capacity in order to match the decreased demand for their products, thus

investment decreases. C↓→ Q↓→ I↓It is more expensive to borrow money for investment purposes (much investment is

financed through borrowing) thus investment decreases. Cost of Borrowing↑→ I↓If the interest rate rises, there will be less investment projects which yield a rate of returngreater than the rate of interest that could be earned from banks, therefore lessinvestment projects will be undertaken, thus investment falls.

Comparative Returns↓→ I↓

THE GOVERNMENT (PUBLIC) SECTOR

OUTPUTGoods / Services

CONSUMPTION (C)

SAVING(Leakage)

TAXATION(Leakage)

HOUSEHOLDS FIRMS

INVESTMENT(Injection)

GOVERNMENT SPENDING

(Injection)

FACTORS OF PRODUCTIONEnterprise, Land,Labour, Capital

FACTOR INCOMESProfit, Rent, Wages, Interest

As our model stands it is still unrealistic as it ignores the huge role played by the government inthe economy. The government raises revenue through taxation (T) and spends the revenue ongoods and services which is known as Government Expenditure (G).

Taxation is a leakage from the circular flow since it represents part of household income whichdoes not flow back to firms in the form of consumption. The higher the level of income tax thelower the level of consumption.

Taxation is a leakage from the circular flow since it represents part ofhousehold income which does not flow back to firms in the form of

TAXATION consumption.

-4-

An increase in the level of taxation by the government.

↓This will lead to lower levels of consumption as consumers have less disposable income.

↓Firms will therefore find that some of their output is going unsold.

↓Firms will respond by cutting back their output and will reduce investment.

↓National income, output and employment will fall.

↓If this leakage continues unchecked, national income, output and employment will eventually fall

to zero.

Fortunately this leakage is offset by the injection of government expenditure (G). This is aninjection because it represents a demand for firm’s output which comes not from households orfrom firms. The higher the level of government expenditure the higher the demand for firm’soutput, this national income, output and employment will rise.

Government spending is an injection into the circular flow of incomeGOVERNMENT and represents demand by government for the output of firm’s

SPENDING

Government spending leads to additional demand for the output of firms.

↓Firms will therefore find that there is an output shortage; they are not creating enough output.

↓They will respond by increasing output and employing a greater number of workers (and other

factors of production).

↓There will be a rise in national income, output and employment as a result.

TAXATION – a leakage from the circular flow of income, if T > G then will lead to a fall inincome, output and employment. This is a DEFLATIONARY situation.

GOVERNMENT SPENDING – an injection into the circular flow of income, if G > T thenwill lead to an increase in income, output and employment. This is an INFLATIONARYsituation.

FISCAL POLICY (demand-side policy)

The level of taxation and government spending in the economy is directly controlled by thegovernment’s Fiscal Policy, so we must look at Fiscal Policy at this stage. Fiscal Policy is underthe control of the government, i.e. the Chancellor of the Exchequer.

The use of Government Expenditure and Taxation to control the

FISCAL POLICY economy.

-5-

EXPANSIONARY FISCAL POLICY

Here government spending > taxation (G > T) which leads to a budget deficit, it expands theeconomy because it leads to greater demand for firm’s output, thus national income, output andemployment will rise.

Amount by which government spending for the year exceeds

BUDGET DEFICIT government revenues from taxation.

Due to this it is often used to try and cut unemployment but may lead to a rise in inflation asdemand in the economy starts to outstrip what can be supplied by the economy and prices rise.

Demand-pull inflation arises when aggregate demand in an economyDEMAND PULL outpaces aggregate supply.

INFLATION

When the government creates a budget deficit (G > T) this must be funded through borrowing.The amount the government needs to borrow in known as the Public Sector Net CashRequirement (PSNCR). The government borrow money by selling bonds / guilt edge securities.These are basically government IOUs which are sold to the population and earn them a rate ofinterest.

Public Sector Net Cash Requirement (PSNCR) is the budget deficitin the UK. It is the difference between Government expenditure and

PSNCR Government income.

When this situation occurs the government is increasing the level of government debt, which isthe total amount of government borrowing that has accumulated over the years.

The amount that a country's government has borrowed as a result of

GOVERNMENTDEBT

budget deficits, usually by issuing government bonds. Often called thenational debt.

CONTRACTIONARY FISCAL POLICY

Here government spending < taxation (G < T) which leads to a budget surplus, it contracts theeconomy because it leads to lower demand for firm’s output, thus national income, output andemployment will fall.

The amount each year by which government income exceeds

BUDGET SURPLUS government spending.

Due to this it is often used to try and cut inflation but may lead to a rise in unemployment.When the government creates a budget surplus this can be used to pay back government debt.When this situation occurs the government is decreasing the level of government debt.

-6-

THE INTERNATIONAL SECTOR – THE OPEN ECONOMY

In order to make the model even more realistic we need to take account of the important roleplayed by international trade, i.e. imports (M) and exports (X).

Commodities (goods or services) bought from a foreign country,

IMPORTS

EXPORTS

leading to a corresponding leakage from the circular flow of income.

Commodities (goods or services) sold to a foreign country, leading toa corresponding injection into the circular flow of income.

OUTPUTGoods / Services

CONSUMPTION (C)

SAVING(Leakage)

TAXATION(Leakage)

IMPORTS(Leakage)

HOUSEHOLDS

FACTORS OF PRODUCTIONEnterprise, Land,

FIRMS

INVESTMENT(Injection)

GOVERNMENT SPENDING

(Injection)

EXPORTS

(Injection)

Labour, Capital

FACTOR INCOMESProfit, Rent, Wages, Interest

Imports are a leakage because they represent part of household income which does not flow backto domestic firms, but instead flows out of the country to foreign firms.

An increase in the level of imports purchased by households.

↓This will lead to lower levels of consumption as money flows out of the UK.

↓Firms will therefore find that some of their output is going unsold.

↓Firms will respond by cutting back their output and will reduce investment.

↓National income, output and employment will fall.

↓If this leakage continues unchecked, national income, output and employment will eventually fall

to zero.

Fortunately exports are a counteracting injection into the circular flow as they represent anadditional demand for domestic firm’s output, which does not come from domestic households,firms or government.

-7-

An increase in the level of exports purchased by foreign countries leads to a greater level ofconsumption as money flows into the UK.

↓Firms will therefore find that there is an output shortage; they are not creating enough output.

↓They will respond by increasing output and employing a greater number of workers (and other

factors of production).

↓There will be a rise in national income, output and employment as a result.

EXCHANGE RATES

The level of imports and exports will depend very much on the exchange rate at the time.Therefore at this stage we need to look at the concept of the exchange rate.

The exchange rate is the price of one currency expressed in terms of

EXCHANGE RATE another.

EXPANSIONARY SITUATION

This occurs when the exchange rate falls which is also known as Depreciation or Devaluation.This means that it becomes cheaper for foreigners to buy pounds and more expensive for us tobuy foreign currency. This means that it become cheaper for foreigners to buy our exports, thusexports rise and it become more expensive for us to buy foreign imports, therefore imports fall.This leads to X > M and demand for domestic firm’s products rise leading to an increase innational income, output and employment. This leads to what is known as an improvement in theBalance of Payments (a change in the balance from out to in). This may also be referred to as a“Trade Surplus”, a “Current Account Surplus” or a “Balance of Payments Surplus”.

Price X↓ and Price M↑→ X > M→ Income/Output/Employment↑

This can be remembered through the acronym DECIM:

DECIM

Depreciation (Devaluation)Exports (become)CheaperImports (become)More Expensive

CONTRACTIONARY SITUATION

This occurs when the exchange rate rises which is also known as Appreciation or Revaluation.This means that it becomes more expensive for foreigners to buy pounds and cheaper for us tobuy foreign currency. This means that it become more expensive for foreigners to buy ourexports, thus exports fall and it become cheaper for us to buy foreign imports, therefore importsrise. This leads to X < M and thus demand for domestic firm’s products falls leading to a decreasein national income, output and employment. This leads to what is known as deterioration in the

-8-

Balance of Payments (a change in the balance from in to out). This may also be referred to as a“Trade Deficit”, a “Current Account Deficit” or a “Balance of Payments Deficit”.

Price X↑ and Price M↓→ X < M→ Income/Output/Employment↓

This can be remembered through the reverse of the acronym DECIM:

DECIM

Depreciation (Devaluation)Exports (become)CheaperImports (become)More Expensive

REVERSE

REVERSE

REVERSE

REVERSE

REVERSE

Appreciation (Revaluation)Exports (become)More ExpensiveImports (become)Cheaper

THE OVERALL MODEL

Whether the economy is expanding or contracting will depend on the balance of all six of theinjections and leakages:

INJECTIONS LEAKAGESIGX

InvestmentGovernment SpendingExports

STM

SavingTaxationImports

EXPANSIONARY SITUATION

This will occur when Injections > Leakages and will lead to an increase in national income,output and employment, in other words the Gross Domestic Product (GDP):

I+G+X>S+T+M

I+G+X

National Income, Output &Employment

-9-

S+T+M

CONTRACTIONARY SITUATION

This will occur when Leakages > Injections and will lead to a decrease in national income, outputand employment, in other words the Gross Domestic Product (GDP):

S+T+M>I+G+X

I+G+X

National Income, Output &Employment S+T+M

EQUILIBRIUM SITUATION

This will occur when Injections = Leakages and will lead to no tendency for a change in nationalincome, output and employment, in other words the Gross Domestic Product (GDP). This isknown as Macroeconomic Equilibrium.

I+G+X=S+T+M

I+G+X

No Change

National Income, Output &Employment

- 10 -

S+T+M