The Circular Flow Model

The Circular Flow Model of Our Economy

Developing a Model of Our Economy

The Circular Flow

Every economy is a dynamic system. The economy is ''moving'', constantly operating. The economy has a ''velocity''; households are consuming, firms are producing - we're moving towards the future. But like a rider on a bicycle, our economy gets the ''wobbles'' from time to time.

Our economy is constantly changing, and reacting to change. And some of this changes include unemployment and inflation; problems that are difficult to solve. To begin to understand how we can improve our economy, we must analyse the components and flows that make up the economy. Economists have developed a model of how an economy works: the Circular Flow Model.

The simplest form of the model is called the two sector circular flow model. In this model, we assume that there are only two areas that need concern us: the household sector and the business sector. (We will introduce the government sector and the overseas sector later).
Households own all economic resources: these are, as you remember, land, labour, capital and enterprise.

Households sell their resources to firms. Firms use these factors of production to produce goods and services. Households are paid for the resources they provide (see the flow ''payments for resources'')

Households are assumed to make no savings. Everything produced is assumed to be sold to households; that is, we do not include investment in the model, yet.

The household sector is us, consumers. The business sector are producers.

Within our model of the economy, there are two clear flows. The first is the outer flow; economic resources are provided to firms, who use them to produce goods and services. This flow is called the real flow of resources and production. The second, inner flow, is the money flow. Firms pay households for their resources, and in turn households use this income to buy goods and services from firms.

It's a ''money go round'', in a sense.

Households spend their income on goods produced by firms. Firms spend their money on production, buying resources from households. The model indicates that total demand will always equal total supply. That is, total spending equals total production. The economy is always in equilibrium; there is no tendency to change.

Output is defined as the quantity of production in a period of time. The total value of production in a year is called our GDP. We will be studying GDP in greater depth in the follwing chapters.

It's unrealistic to assume people consume every dollar they earn. Let's introduce saving into our model. Households save part of their income in financial institutions. This act of saving is called a leakage from the circular flow model. This is because the money is not spent on goods and services produced by firms, and it will reduce the velocity of the circular flow. If households don't consume, firms will soon reduce production. Why make things people don't buy?
In reality, the picture is more complex than that.

Not everything that is produced is immediately consumed. Investment is defined as that part of production that is not consumed in the current period of time. Investment has two components;

changes in the level of capital used by the firm,

and changes in the level of stocks, finished goods ready for sale.

Investment is an injection into the Circular Flow. Resources are used and paid for in a period of time. The consumption of the item may occur next period, but the money flow occurs today.

Investment

To make goods and services, firms need capital - other goods and services used in production. Many capital items, such as factory equipment, will be used for many periods of time. A truck is a capital item, if it is used to deliver your production to consumers (or other firms). A truck will last for several years. Thus, not all of the value of the truck is consumed in production in the current period. The truck is said to depreciate. The value and usefulness of the truck declines over time.

All goods have to be produced before they can be consumed. For many goods, the time between production and consumption by households can be quite long. Some goods may be produced in one year, and consumed (sold) in the next. Consider new motor vehicles, for example. Car makers must produce considerable numbers of a new model each year, that is, increase their stocks before any are sold. Clearly, for several months at least, production will be greater than sales (or consumption). Stocks will rise. As the year progresses, the car maker will make fewer cars, because they do not want too many unsold cars at the end of the year. Thus, in another part of the year, sales (or consumption) will be greater than production. Stocks will fall.

Firms also do not use up their capital goods at the same rate as they produce goods and services. When a machine reaches the end of its useful life, it is replaced, but it may only be replaced every five years.

Investment is ''uneven''; in some years more is spent than in other years.

A Little Mathematics

Households either consume their income or save it. Economists use mathematics to express this reality.

We say Y = C + S

(where ''Y'' is income, ''C'' is consumption and ''S'' is saving.)

Total spending by firms is made up of two components. Firms spend money on production that is sold in the current period (C (that is, production that is consumed in the period it was produced), and they also spend money on investment or I. Investment by firms includes the production of goods that will be sold in a future period of time (we call these stocks), as well as spending on new capital goods.

We can say Y = C + I

(where ''Y'' is total spending, ''C'' is production that is consumed in the same period of time it is produced and ''I'' is investment.)

Key Concept : The level of income (''Y'') in our economy depends on the level of consumption by households and the level of investment by firms.

It is crucial you understand the meaning and ''sense'' of the equations above. Re-read this section if you are unclear.

The Hidden Implications of ''S'' and ''I''

If firms do not have enough financial resources of their own for investment, they will borrow from financial institutions. To increase stocks requires raw materials and labour. Your workers want to be paid each fortnight. They are not interested in waiting for three or four months before the goods they have produced are finally sold, so they can get their money. Firms borrow on a short term and on a long term basis. Capital goods are expensive and may be bought using secured loans or leasing. Stock may be financed by increasing a firm's overdraft.

Investment by firms is an injection of funds into the circular flow. Resources are used in investment, and they must be paid for.

However, there is no reason for the amount of investment in a period of time to be exactly equal to the level of saving.

The decision to save is made by millions of households; the decision to invest is made by thousands of firms. The plans of one group are not known by the other group.

When ''S'' equals ''I'' : When Leakages = Injections

Firms have to be able to estimate the level of future consumption by households. Goods must be made before they are sold. Firms are risk takers because they are basing production on their best estimates of what they hope demand will be. And guesses can often be wrong.

If firms are correct in their forecasts, the level of production will equal the level of demand, and stock levels will remain at acceptable levels. If firms get it wrong, and households spend less, than firms thought they would, production levels will be higher than the level of sales; stocks will rise. If households spend less, they must be saving more.

If firms have got it right, then the ''C'' part of production in the current period by firms will equal the ''C'' part of the income of households that is consumed in the current period. If these ''C's'' are equal, the level of investment by firms will equal the level of savings of households.

This means that if planned savings equals planned investment, (that is ''S'' equals ''I''), then leakages from the circular flow will equal injections into the circular flow. The economy is said to be in equilibrium. Our national income (Y) will reach a given level, a certain ''velocity'', and stay there.

We can combine our two equations. At equilibrium, spending by firms equals income received by households.

Y = Y

That is,

Y = C + S and Y = C + I

cancelling out the ''C's'' leaves us with

I = S

There will be no tendency for the level of production, and therefore the level of employment in the economy to change. Everything is running smoothly in our economy; the level of stocks stays steady, unemployment does not increase, firms will not change their productions plans. Income will stay steady.

When ''S'' is Greater than ''I''

If households decide to save more than firms decide to invest, then clearly households are not consuming at the rate firms expected them to. Leakages from the circular flow will be greater than injections. Firms will not sell the amount of production they thought they would to households. Stocks (unsold goods, ready for sale), held by firms will rise. Firms will notice this increase in stocks, and will realise that more money is leaving their businesses (through spending on resources and investment) than is coming in (through sales). You can't have more money going out of your business than coming in; eventually your firm will go run out of money. (Your business will go ''broke'').

What would you, the ''entrepreneur'' do, if you were the owner of this firm?

Well done if you said, ''I'll cut back on production'' !

This is exactly what happens in our economy. When households don't consume production at the rate that firms thought they would, firms reduce the level of production. When you, as a firm, reduce the level of your production, you don't need as many resources as you did before. You will probably reduce the level of employment in your firm, and buy less raw materials. We'll assume that you will maintain your current level of investment on new capital goods and you will keep stocks (for future sales) at the same level.

In the diagram above, the initial flow of income in an economy is $10,000 per month. Households decide to save 20% ($2,000) of this income and consume $8,000 in the first month. Firms had expected households to consume $9,000 this month (that is, to only save $1,000) and had set production levels at $9,000 in their factories.

How did I arrive at $9,000? Firms had spent the $10,000 of money income, as it past through their hands in month 1. They spent $1,000 on investment in capital and stocks and $9,000 in production that was expected to be sold in month 1.

Let's assume firms will continue to invest $1,000 each month. Since households only spend $8,000 in month 1, firms will lower production to a new level of $8,000, ready for period 2. This means less money is injected back into the economy in the form of wages and payments for materials. The $1,000 sits in the bank unused, while unsold goods get dusty on factory shelves.

Household income at the end of month 1 is C + I : $8,000 + $1,000 = $9,000.

At the start of month 2, households still decide to save 20% of their income. Twenty per cent of $9,000 is $1,800. Consumption, therefore is $9,000 - $1,800 = $7,200.

But firms had anticipated households would only save $1,000 and spend $8,000 during period 2! Households actually saved $1,800 ; $800 more than firms had expected.

Firms decrease production in month 2 by $800. Stocks of unsold production continue to rise. Firms now only reinject $8,200 into the economy in month 3 ($7,200 in payments for production actually sold and $1,000 in investment spending).

The diagram above shows the effect of repeated cycles of production for consumption not equalling consumption, or, equivalently, saving not equalling investment.

Eventually, production for consumption will fall to $4,000; and finally all that is produced will be sold. Stocks will stop rising. However, household income has fallen to $5,000. Our economy is probably experiencing high levels of unemployment. Firms will not need as much labour and raw materials for production.

When saving is greater than investment in an economy, production falls. It is likely that unemployment will rise.

National income (''Y'') will fall.

The economy is no longer ''steady'' or in ''equilibrium''; economists say the economy is in a state of disequilibrium, until a new level of steady production occurs. This will occur when planned savings equals planned investment.

What happens next? One possible outcome is that interest rates will fall, in the financial sector. After all, savings have accumulated in banks and other deposit takers. Financial institutions are getting more money in deposits than they they are lending. Banks and other credit providers have to pay interest on money deposited. They get the money to pay interest by charging lenders interest. (Another ''money go round'').

Clearly, banks have to encourage borrowers to borrow more. Banks can do this by reducing the interest rates they charge on loans.

If borrowing becomes less expensive, households, (who fund a lot of spending through borrowing), will borrow more. This means that household consumption will rise. Firms will notice stocks falling, and they will have to increase production. This means that households will receive greater incomes (as they provide the resources used in production by firms).

Hopefully, unemployment will fall, as production rises. And, hopefully, the equilibrium between saving and investment will be reestablished.

When ''S'' is Less than ''I''

If households increase C then they will have to decrease their level of savings. What happens when households spend more on consumption than firms anticipated? Firms maintain inventories (another name for ''stocks'') for just this reason. No firm wants to have to turn customers away. Stocks are maintained as a ''buffer'', so that if sales unexpectedly increase, there are goods that can be offered immediately.

If stock levels fall, firms will increase production, to maintain the ''buffer''. Increases in production will create greater demand for resources, households will receive higher incomes and unemployment is likely to decrease.

National income will rise.

The higher incomes received by households will induce further spending and consumption. This in turn will see stocks falling again; firms will increase production, employment and income will rise again. We're on the ''money go round'' again, and the economy is doing better. As incomes rise, savings rises as well. The ''initial'' increase in spending has ''induced'' further rounds of spending, but the size of each round of spending is reduced, because part of the increase in income is saved. It's like ''ripples'' in a pond, when you throw in a stone. The ripples will spread, but eventually die away.

The economy is like a car. When consumption rises, the economy ''accelerates'' until it reaches a higher ''velocity'', or level of national income. Once the car has reached the required speed, you stop accelerating. Eventually, the economy reaches a higher speed; a new equilibrium, which has associated with it higher levels of income and employment.

Adding the Government and Overseas Sectors

The Government Sector

The Government sector includes all three layers of government in Australia; local, state and Federal. The Federal Government has the greatest impact on our economy. The Federal Government levies a wide variety of taxes and charges on groups operating in our economy. Households pay income tax; firms pay company tax. Importers of goods into Australia may pay tariffs (taxes levied only on imports, not Australian made goods). Taxation is a leakage from the circular flow, and is given the symbol T.

The Federal Government uses the money collected through taxation to support a range of Budgetary programs throughout the year. Government spending is given the symbol G. The Government is responsible for a range of transfer payments to the less well-off and disadvantaged groups in our society. (Indeed, one third of the $125 billion the Government spends each year is channeled through the Department of Social Security). Transfer payments include the unemployment benefit (the ''dole''), sickness benefits, pensions, and a wide range of other support programs.

The Government also spends money each year on the salaries of public servants. (Payments of wages and benefits to households are called recurrent expenditure, because these happen every year). The Government also spends money on capital items, such as roads, hospitals and other important items of social overhead capital, without which commerce in Australia would not be as efficient.

Government spending is an injection into the circular flow. Increased government spending will tend to increase economic activity, increasing production and employment generally.

Most taxation is collected by the Federal Government, and grants are made to the States each year, out of the Federal Budget. The State Governments are responsible for large areas of spending; for example on primary and secondary education, and large areas of health care. The State governments often complain about fiscal imbalance; the Federal government collects most of the taxation revenue, and the states have limited taxing abilities. The states actually spend more than they collect in taxes. They argue that the Federal government should let the states collect more of their own taxes. Others argue that this would favour the larger, eastern, states, who would be able to set lower tax levels on a wide range of items, thus attracting business to the east, disadvantaging the smaller states like South Australia. Allowing each state to set its own taxes would encourage competiton between the states, and do little to further the economic growth of Australia as a whole. What do you think?

If the Federal Government spends more in a year than it raises in taxation, we can say G > T.
The Federal Government is ''running a Budgetary deficit''. National income will tend to rise, as more money is injected into our economy than ''leaks'' out.

If the Federal Government less more in a year than it raises in taxation, we can say G < T.
The Federal Government is ''running a Budgetary surplus''. National income will tend to fall, as leakages of funds will be greater than injections.

If the Federal Government spends as much as it receives in taxation, we can say G = T.
The Federal Government is ''running a balanced Budget''. National income will not change, as leakages from and injections into the circular flow are equal.

The Overseas Sector

Australia has an ''open'' economy. About 20% of all our total consumption is made up of goods and services produced overseas. About 20% of our total production is exported. The overseas sector is a vital part of our economy. Australia also has a high level of foreign investment, and we are, increasingly, becoming a large investor ourselves in other economies.

Exports of goods and services are an injection into our economy, as the income received from the sale of exports returns to our own domestic (local) economy. An increase in exports increases our national income.

Imports are a leakage from our circular flow, because the money used to pay for imports ends up overseas, and does not continue to circulate within our own local economy. An increase in imports will see our national income fall.

Foreign investment, like domestic investment, in our economy is an injection; it helps to increase production and employment within Australia. However, foreign individuals and firms only invest in Australia to make a profit. When the profits from foreign owned firms are sent back to the investors home country, this ''profit repatriation'' is a leakage from our economy.

When the total amount of money flowing out of our economy (we will call this M, for the moment), is greater than the amount of money flowing into to our economy (X), that is M > X, we say our economy is experiencing a Balance of Payments deficit. There has been a net leakage from our circular flow.

A deficit on the Balance of Payments will tend to reduce national income.

A Balance of Payments surplus on the other hand occurs when X > M. A surplus on the Balance of Payments tends to increase national income, employment and production. A surplus on the Balance of Payments is a net injection into our circular flow.

In the two sector model of the economy, employment and production reached an equilibrium when injections of funds into the economy equals the leakages. Injections were, as you will recall, made up of investment by firms and leakages were savings by households. We can now add the other ''leakages'' and ''injections'' mentioned above into our model.

In ''four sector'' model of our economy, leakages are actions that slow down the rate of movement of resources and income through the circular flow of our economy. Saving is a leakage; and so is taxation and expenditure on imports.

Actions that increase the flow of income and resources within our economy include government spending, and investment by firms. Exports add to our income, and also are an injection. Our economy will reach an equilibrium when total leakages equal total injections :

Leakages = Injections

S + T + M = I + G + X

You will note that G - T is the government's Budget deficit or surplus.

If leakages (the variables on the left hand side of this equation) are, in total, greater than the injections (the variables on the right hand side), then the economy will tend to ''contract''. Production and income will fall, and unemployment will rise.

Defining Aggregate Demand

We can use the model to help us define further concepts. In our economy, demand for goods and services arises from the consumption decisions of households (''C''), the investment decisions of firms (''I''), the spending by Government(s) (''G''), the demand for our exports (''X''), less spending on imports (''M'', because the goods and services demanded are not produced in our domestic economy).

Economists define Aggregate (or ''total'') Demand (which is the same as National Income or Gross Domestic Product) as

Y = C + I + G + X - M

This is an important equation; it should be clearly understood.

Revision Exercises

Follow this link to a Index of Revision Questions (Set 2) on Introduction to Economics.

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