Macroeconomics

Week 4
THE CIRCULAR FLOW
CIRCULAR
FLOW DIAGRAM
is a visual model of the economy
that shows how money flows
through markets among
households and firms.
THE CIRCULAR FLOW
PRODUCTION,
RESOURCES, &
INCOME
FACTORS OF
PRODUCTION
Land (rent)
Labor (labor)
Capital (interest) ; and
Entrepreneurship (profit)
THE CIRCULAR FLOW
INTEGRATING PRODUCTION &
AND CONSUMPTION
Money creates income every
time it changes hands in the
market system. On the other
hand, the amount of money
available for use in the two-
household economy is not
equal to income.
Income is a FLOW concept as it
is generated and measured for
a period of time.

Wealth is a STOCK concept as
it refers to all materials which
possess economic value owned
by the populace.
THE CIRCULAR FLOW
PRODUCTION UNITS &
AND CONSUMPTION UNITS

Production is organized by
FIRMS and not
HOUSEHOLDS.

HOUSEHOLDS are resource
owners (land, labor, capital,
entrepreneurship)

FIRMS produce goods and
services by utilizing the
economic resources.
THE CIRCULAR FLOW
PRODUCTION UNITS & CONSUMPTION UNITS
In this model, funds
flow from FIRMS to
HOUSEHOLDS,
producing MONEY
INCOME (wages,
rentals, interests, and
profits) for the
HOUSEHOLDS
arising from the use of
resources.
THE CIRCULAR FLOW
HOUSEHOLD AND
INTERDEPENDENT
PRODUCTION UNITS
Not all firms produce
consumer goods and there are
stages of production to undergo
to produce a final product or
output.

Concept of Value Added: For
each stage in the production
process adds to the value of the
final product.

It is the production of final
goods and services that is
relevant in arriving at national
income
The Circular Flow of Economic Activity
THE CIRCULAR FLOW
INJECTIONS
AND
LEAKAGES
It is a fact that not
all income and
expenditures
circulate
continuously.
In reality, there
are OUTFLOWS
(Leakages) from
and INFLOWS
(INJECTIONS) into
the circular flow.
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BANKS
SAVINGS
(S)

TAXES
(T)
GOVERNMENT
IMPORTS
(M)
REST OF THE WORLD
INVESTMENT
(I)

GOVERNMENT
SPENDING (G)

EXPORTS (X)

5-SECTOR CIRCULAR FLOW
OUTFLOWS
: Savings
(S), Taxes
(T), and
Imports (M)
INFLOWS:
Investment (I),
Government
Spending (G),
and Exports
(X)
S + T + M
=
I + G + X or
OUTFLOWS
=
INFLOWS