The Circular Flow Model The circular flow model illustrates the economic relationships among all players in the economy: households, firms, the factors market, the goods-and-services market, government, and foreign trade. What is a market? The circular flow of income describes these flows of dollars (pesos, euros, or whatever). As individuals and firms buy and sell goods and services, money flows among the different sectors of an economy. The circular flow of income demonstrates how economists calculate national income, or gross domestic product (GDP). [***The circular flow is introduced in Chapter 3 "The State of the Economy". Example of Circular Flow Diagram Let’s take a tour of the circular flow by following a dollar bill as it makes its way from person to person through the economy. Spending and income continue to circulate around the macro economy in what is referred to as the circular flow of income. The circular flow of income describes these flows of dollars (pesos, euros, or whatever). A market is a place or situation where an exchange takes place. Suppose we add saving and investment to the circular flow. As consumers we have to make choices as there are scarce resources to satisfy our unlimited needs and wants. Some of the income is saved, used to pay taxes or spent on imported goods and services. Taxes – taxes are withdrawn from the circular flow, and results in reduced spending and income. Basic framework of an economy and Circular Flow of Income • There are many ways to look into the Circular Flow of Income Model. ***Figure 5.8 "The Flows In and Out of the Financial Sector" reviews the four flows of dollars in and out of the financial sector. The Dual Categories for Economic Actors, Markets, and Cycles Within this model, all economic actors are placed into one … There is no saving (S). The circular flow of income describes the flows of money among the five main sectors of an economy. Likewise, sometimes there is extra spending in the economy,from investment, government expenditure and spending on exports, which will be added to the circular flow of income. In general, the circular-flow model is useful because it informs the creation of the supply and demand model. The circular flow of income and expenditure in such an economy is shown in Figure 1 where the product market is shown in the upper portion and the factor market in the lower portion. Imports – the goods come into the country but the money goes to the rest of the … What households (consumers) want and can afford (their demand) determines what firms will produce. Unit 1 The open economy circular flow model Introduction The circular flow model shows us how the economy functions by illustrating the relationship in the economy between production, income and spending. Over a period of time there are withdrawals (W) from the income flow. QUESTION THREE (20 Marks) Use Figure 2 to fully discuss the welfare effect of setting a minimum wage of R 13/hr above or below the equilibrium wage. The goods, services, and productive factors are priced, but the way in which their prices are determined pertains to the market mechanisms and not to circular flow model. Circular Income Flow in a Two Sectors economy: Real flows of resources, goods and services have been shown in Fig. Exports are an injection or inflows into the economy. So the profit is $500 and so his total income is $3,500, $3,500 and it's good that his income is at least $3,500 because that's how much he's spending it per month, spending per month. In the upper loop of this figure, the resources such as land, capital and entrepreneurial ability flow from households to business firms as indicated by the arrow mark. • First we will discuss the two sector model. In addition to spending and distributing money in this circular flow model, the government is also a cause of “leakage”—that is, the removal of money from the system through taxes. So, factor payments flow from firms (producing units) to households. If, out of extra income, people spend their money on imports, this demand is not passed on in the form of fresh spending on domestically produced output. Hence, spending on goods and services flows from households to firms, and income in the form of wages, rent, and profit flows from firms to households. The characteristics of households may be summarised as follows: They are owners of production factors. It leaks away from the circular flow of income and spending, reducing the size of the multiplier. If an economy's income is Rs.1,000 and it saves Rs.200, then only Rs.800 is passed on as expenditure. Explain the likely effects on the circular flow of income of the change in unemployment between 2013 and 2015. Other withdrawals are taxes and imports. In the macroeconomy, spending must always equal income. The final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to an open economy. The main withdrawals from the circular flow of income are: Savings – households save part of their income, when they save there is a withdrawal in the circular flow of income and spending. The circular flow then involves financial markets. The basic circular flow of income model consists of seven assumptions: The economy consists of two sectors: households and firms. If individuals save, then the income is taken out of the circular flow. The households spend their entire income on goods and services and do not save any money. To complete the circular income of income and expenditure in a three-sector closed model, the government sector is added. Therefore saving, taxation and imports are leakages in the circular flow of income. (Context - a graph is provided showing unemployment falling by around 3%).As unemployment fell by 3% between 2013 and 2015, there will be an increase in money in the circular flow of income as more people are now receiving wages. In the product market, the household sector purchases goods and services from the business sector while in the factor market the household sector receives income from the former for providing … No diagram is required. 4. The main leakage from this sector are imports (M), which represent spending by residents into the rest of the world. The total savings of households + the total tax revenue of the government + the total income from exports = always equal to the total expenditure of the financial sector (loans) + Total government spending + spending on imports. All output (O) produced by firms is purchased by households through their expenditure (E). Households spend all of their income (Y) on goods and services or consumption (C). Investment spending is an injection into the circular flow of income.. Investment refers to an increase in capital assets, and typically includes investment by business, investment in property (‘dwellings’) and investment by governments in ‘social’ capital. e.g. Circular Flow of Money with the Foreign Sector: So far the circular flow of income and expenditure has been shown in the case of a closed economy. This market facilitates the flow of savings from the household sector and investment by businesses. 31.27 The Circular Flow of Income. A change in their behaviour (even a small one) has a significant impact on the flow of production, income and spending. 16.16 The Circular Flow of Income. The circular flow of income model is based on the comparison S + T + M = I + G + X. 2.1. The circular flow of the economy 2 1. Here, government purchases are injections into the circular flow, while, taxation is a leakage.