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Chapter 8

Chapter 8 . The Circular Flow Model. © 2003 South-Western College Publishing. Circular Flow of Income. Because land, labor and capital are generally owned by households, firms must pay for their use

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Chapter 8

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  1. Chapter 8 The Circular Flow Model © 2003 South-Western College Publishing

  2. Circular Flow of Income • Because land, labor and capital are generally owned by households, firms must pay for their use • This payment along with profits become income and purchasing power that can be used to buy goods and services • These payments are referred to as resource income

  3. Circular Flow of Income • The demand for goods and services by the recipients of resource income leads to more output, which in turn brings about additional payments of resource income • This cyclical operation of demand, output, income, and new demand is illustrated by the circular flow of income diagram • The size of the circular flow measures the level of income and output in the economy

  4. Leakages • Resource income and spending are not always equal because of • Leakages which flow out of the circular flow that occur when resource income is received and not spent directly on purchases from domestic firms • Saving • Taxes • Import purchases

  5. Injections • However, at least some of these leakages are returned to the circular flow via various injections • Added spending into the circular flow that are not paid out of resource income • Investment, government spending, and exports bought by foreign buyers

  6. Circular Flow - Simple Model Households offer their productive services to businesses in exchange for pay in the form of wages, rent, and interest and owners receive profits Resource Income $$$ Productive Services Businesses Households Income recipients use their money to buy goods and services produced by business Goods and Services $$$ Spending for Goods and Services

  7. Stable Economy • If all income is spent • business will sell all goods, and • will be induced to produce all goods again

  8. Stable Economy • Leakage in the circular flow • savings • Injection in the circular flow • investment

  9. Savings and Investment If planned investment(I) = planned savings(S) so that injections = leakages and total spending = total income and demand = supply then we have a stable economy

  10. Contracting Economy • If leakages exceed injections, we have a contracting economy resultingin • inventory accumulation • too little spending • drop in prices • and...Planned I < Planned S

  11. Expanding Economy • If injections are less than leakages, we have an expanding economy resulting in • more goods and services produced • higher prices • and... Planned I > PlannedS

  12. Changes in Prices • Whenever leakages exceed injections, it is also possible that the market can be cleared in the price level falls • When injections exceed leakages, increases in the price level will cause the market to clear

  13. Equilibrium in the Circular Flow • Equilibrium • A stable flow of total output and income • Planned I = planned S  injections = leakages • Price level is stable

  14. Equilibrium in the Circular Flow • Planned I < planned S • Injections < leakages • Total income and output or the price level tend to decrease • Income falls, saving decreases until it comes back into balance with investment

  15. Equilibrium in the Circular Flow • Planned I > plannedS • Injections > leakages • Total income and output tend to increase, if the economy is at less than full employment  income and saving increase until it comes into balance with investment • If the economy is at full employment, the price level tends to increase

  16. Government & Circular Flow • Balanced budget • amount spent by government = amount collected in taxes • Surplus budget • amount spent by government = less than that collected in taxes • Deficit budget • amount spent by government = more than that collected in taxes

  17. International Trade & Circular Flow • Imports are a leakage • Exports are an injection • If exports = imports, the circular flow is in balance • Usually it is not balanced • called a trade deficit, because imports (leakages) are greater than exports (injections)

  18. Influences on the Circular Flow • Government budget • surpluses • deficits • International trade and finance • Asian financial crisis

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