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

This is because the money is not spent on goods and services produced by firms. Output is defined as the quantity of production in a period of time. Firms spend their money on production. Investment has two components. and it will reduce the velocity of the circular flow. If households don't consume. inner flow. if it is used to deliver your production to consumers (or other firms). Resources are used and paid for in a period of time. It's a ''money go round''. is the money flow. finished goods ready for sale.   changes in the level of capital used by the firm. Investment is defined as that part of production that is not consumed in the current period of time. The total value of production in a year is called our GDP. but the money flow occurs today. and in turn households use this income to buy goods and services from firms. not all of the value of the truck is consumed in production in the current period. The second. The economy is always in equilibrium. total spending equals total production.other goods and services used in production. The truck is said to depreciate. there is no tendency to change. Let's introduce saving into our model. will be used for many periods of time. We will be studying GDP in greater depth in the following chapters. Many capital items. Investment To make goods and services. Why make things people don't buy? In reality.and production. . buying resources from households. A truck is a capital item. Not everything that is produced is immediately consumed. That is. Thus. Households save part of their income in financial institutions. firms need capital . such as factory equipment. The consumption of the item may occur next period. A truck will last for several years. and changes in the level of stocks. The value and usefulness of the truck declines over time. firms will soon reduce production. Firms pay households for their resources. The model indicates that total demand will always equal total supply. This act of saving is called a leakage from the circular flow model. Investment is an injection into the Circular Flow. the picture is more complex than that. It's unrealistic to assume people consume every dollar they earn. Households spend their income on goods produced by firms. in a sense.

and they must be paid for. Your workers want to be paid each fortnight. the time between production and consumption by households can be quite long.) Total spending by firms is made up of two components. and they also spend money on investment or I. because they do not want too many unsold cars at the end of the year. as well as spending on new capital goods. We say Y=C+S (where ''Y'' is income. It is crucial you understand the meaning and ''sense'' of the equations above. Stocks will rise. Car makers must produce considerable numbers of a new model each year. Investment is ''uneven''. Investment by firms includes the production of goods that will be sold in a future period of time (we call these stocks). Thus. so they can get their money. for several months at least. it is replaced.) \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. . production will be greater than sales (or consumption).All goods have to be produced before they can be consumed. As the year progresses. The Hidden Implications of ''S'' and ''I'' If firms do not have enough financial resources of their own for investment. Firms spend money on production that is sold in the current period (C (that is. Stocks will fall. in another part of the year. We can say Y=C+I (where ''Y'' is total spending. ''C'' is consumption and ''S'' is saving. for example. Investment by firms is an injection of funds into the circular flow. Re-read this section if you are unclear. They are not interested in waiting for three or four months before the goods they have produced are finally sold. they will borrow from financial institutions. Some goods may be produced in one year. Firms also do not use up their capital goods at the same rate as they produce goods and services. and consumed (sold) in the next. the car maker will make fewer cars. Resources are used in investment. in some years more is spent than in other years. To increase stocks requires raw materials and labour. production that is consumed in the period it was produced). A Little Mathematics Households either consume their income or save it. Clearly. For many goods. sales (or consumption) will be greater than production. When a machine reaches the end of its useful life. ''C'' is production that is consumed in the same period of time it is produced and ''I'' is investment. Capital goods are expensive and may be bought using secured loans or leasing. but it may only be replaced every five years. that is. Consider new motor vehicles. Economists use mathematics to express this reality. Firms borrow on a short term and on a long term basis. increase their stocks before any are sold. Stock may be financed by increasing a firm's overdraft.

and stock levels will remain at acceptable levels. And guesses can often be wrong. Goods must be made before they are sold. Everything is running smoothly in our economy. Leakages from the circular flow will be greater than injections. When ''S'' is Greater than ''I'' If households decide to save more than firms decide to invest. If households spend less. Firms will notice this increase in stocks. If firms get it wrong. unemployment does not increase. and therefore the level of employment in the economy to change. the level of investment by firms will equal the level of savings of households. Firms will not sell the amount of production they thought they would to households. then clearly households are not consuming at the rate firms expected them to. If these ''C's'' are equal. than firms thought they would. If firms are correct in their forecasts. If firms have got it right. (that is ''S'' equals ''I''). the level of stocks stays steady. production levels will be higher than the level of sales. Y That is. ready for sale). You can't . = Y 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. 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. and households spend less. The decision to save is made by millions of households. Firms are risk takers because they are basing production on their best estimates of what they hope demand will be. The economy is said to be in equilibrium.However. At equilibrium. they must be saving more. then leakages from the circular flow will equal injections into the circular flow. spending by firms equals income received by households. held by firms will rise. Income will stay steady. Stocks (unsold goods. 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. a certain ''velocity''. Our national income (Y) will reach a given level. We can combine our two equations. and will realise that more money is leaving their businesses (through spending on resources and investment) than is coming in (through sales). This means that if planned savings equals planned investment. firms will not change their productions plans. the level of production will equal the level of demand. 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 invest is made by thousands of firms. and stay there. stocks will rise.

Since households only spend $8.000 in production that was expected to be sold in month 1. ''I'll cut back on production'' ! This is exactly what happens in our economy. (Your business will go ''broke'').000) of this income and consume $8. They spent $1. In the diagram above. reduce the level of your production. and buy less raw materials.000 in month 1.000 of money income. the initial flow of income in an economy is $10. if you were the owner of this firm? Well done if you said.000 in their factories. When you. ready for period 2. Let's assume firms will continue to invest $1. firms will lower production to a new level of $8. .000 + $1. while unsold goods get dusty on factory shelves. the ''entrepreneur'' do.000? Firms had spent the $10.000. What would you.have more money going out of your business than coming in.000.000 this month (that is.000) and had set production levels at $9. as it past through their hands in month 1. eventually your firm will go run out of money. 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. This means less money is injected back into the economy in the form of wages and payments for materials. firms reduce the level of production. as a firm. you don't need as many resources as you did before. Household income at the end of month 1 is C + I : $8. How did I arrive at $9. You will probably reduce the level of employment in your firm. The $1.000 sits in the bank unused.000 each month.000 in the first month.000 on investment in capital and stocks and $9. Firms had expected households to consume $9.000 per month. to only save $1. Households decide to save 20% ($2.000 = $9. When households don't consume production at the rate that firms thought they would.

unemployment will fall. therefore is $9. Firms will not need as much labour and raw materials for production. Eventually.200. When saving is greater than investment in an economy.000. savings have accumulated in banks and other deposit takers. Twenty per cent of $9. This means that households will receive greater incomes (as they provide the resources used in production by firms).$1.000 during period 2! Households actually saved $1. Banks can do this by reducing the interest rates they charge on loans. (who fund a lot of spending through borrowing). Financial institutions are getting more money in deposits than they they are lending. The economy is no longer ''steady'' or in ''equilibrium''. This means that household consumption will rise.200 in payments for production actually sold and $1.800 = $7. and finally all that is produced will be sold. This will occur when planned savings equals planned investment.800 . Stocks of unsold production continue to rise. The diagram above shows the effect of repeated cycles of production for consumption not equaling consumption. economists say the economy is in a state of disequilibrium.000 is $1. households still decide to save 20% of their income.800. $800 more than firms had expected. If borrowing becomes less expensive. and they will have to increase production. However.000. Firms will notice stocks falling. It is likely that unemployment will rise. And. until a new level of steady production occurs. Firms decrease production in month 2 by $800.At the start of month 2. or. . the equilibrium between saving and investment will be reestablished. (Another ''money go round''). banks have to encourage borrowers to borrow more. Clearly. But firms had anticipated households would only save $1.000 . hopefully. Banks and other credit providers have to pay interest on money deposited. After all. They get the money to pay interest by charging lenders interest. equivalently. production for consumption will fall to $4. saving not equalling investment. in the financial sector.000 in investment spending). Firms now only reinject $8. households. Hopefully. household income has fallen to $5.200 into the economy in month 3 ($7. will borrow more. Stocks will stop rising. production falls. What happens next? One possible outcome is that interest rates will fall.000 and spend $8. Our economy is probably experiencing high levels of unemployment. Consumption. as production rises. National income (''Y'') will fall.

The Federal Government has the greatest impact on our economy. If stock levels fall. This in turn will see stocks falling again. The higher incomes received by households will induce further spending and consumption. hospitals and other important items of social overhead capital. so that if sales unexpectedly increase. Increases in production will create greater demand for resources. and a wide range of other support programs. employment and income will rise again. without which commerce in Australia would not be as efficient. (Indeed. Increased government spending will tend to increase economic activity. No firm wants to have to turn customers away. to maintain the ''buffer''. the economy reaches a higher speed. firms will increase production. As incomes rise. Households pay income tax. firms pay company tax. local. because part of the increase in income is saved. firms will increase production. The Federal Government levies a wide variety of taxes and charges on groups operating in our economy. because these happen every year). state and Federal. Eventually. When consumption rises. and is given the symbol T. What happens when households spend more on consumption than firms anticipated? Firms maintain inventories (another name for ''stocks'') for just this reason. you stop accelerating. households will receive higher incomes and unemployment is likely to decrease. increasing production and employment generally. Transfer payments include the unemployment benefit (the ''dole''). savings rises as well. Once the car has reached the required speed. It's like ''ripples'' in a pond. and the economy is doing better. The economy is like a car. . pensions. Taxation is a leakage from the circular flow. or level of national income. but eventually die away. The ''initial'' increase in spending has ''induced'' further rounds of spending. The Federal Government uses the money collected through taxation to support a range of Budgetary programs throughout the year. when you throw in a stone. Government spending is given the symbol G. Stocks are maintained as a ''buffer''.When ''S'' is Less than ''I'' If households increase C then they will have to decrease their level of savings. the economy ''accelerates'' until it reaches a higher ''velocity''. which has associated with it higher levels of income and employment. The Government is responsible for a range of transfer payments to the less well-off and disadvantaged groups in our society. The Government also spends money on capital items. The ripples will spread. (Payments of wages and benefits to households are called recurrent expenditure. not Australian made goods). The Government also spends money each year on the salaries of public servants. there are goods that can be offered immediately. a new equilibrium. sickness benefits. one third of the $125 billion the Government spends each year is channeled through the Department of Social Security). National income will rise. Government spending is an injection into the circular flow. but the size of each round of spending is reduced. such as roads. Importers of goods into Australia may pay tariffs (taxes levied only on imports. Adding the Government and Overseas Sectors The Government Sector The Government sector includes all three layers of government in Australia. We're on the ''money go round'' again.

we say our economy is experiencing a Balance of Payments deficit. Imports are a leakage from our circular flow. becoming a large investor ourselves in other economies. and grants are made to the States each year. Australia also has a high level of foreign investment. for the moment).Most taxation is collected by the Federal Government. Others argue that this would favour the larger. who would be able to set lower tax levels on a wide range of items. Foreign investment. About 20% of our total production is exported. If the Federal Government less more in a year than it raises in taxation. disadvantaging the smaller states like South Australia. when Australian firms invest in activities overseas. we can say G = T. The State Governments are responsible for large areas of spending. out of the Federal Budget. as leakages of funds will be greater than injections. states. The states actually spend more than they collect in taxes. as leakages from and injections into the circular flow are equal. that is M > X. as more money is injected into our economy than ''leaks'' out. and we are. Similarly. the Federal government collects most of the taxation revenue. in the form of profit repatriation back to Australia. The Federal Government is ''running a balanced Budget''. The overseas sector is a vital part of our economy. This view is rather ''short sighted''. National income will tend to fall. . eastern. The Federal Government is ''running a Budgetary deficit''. but it will (hopefully) provide a long term benefit. Such investment will tend to reduce the level of economic activity in Australia. and do little to further the economic growth of Australia as a whole. like domestic investment. foreign individuals and firms only invest in Australia to make a profit. They argue that the Federal government should let the states collect more of their own taxes. because the money used to pay for imports ends up overseas. When the total amount of money flowing out of our economy (we will call this M. Exports of goods and services are an injection into our economy. increasingly. we can say G > T. in our economy is an injection. The State governments often complain about fiscal imbalance. National income will not change. Australian investment overseas may be a short term cost. The Federal Government is ''running a Budgetary surplus''. and does not continue to circulate within our own local economy. When the profits from foreign owned firms are sent back to the investors home country. we can say G < T. What do you think? If the Federal Government spends more in a year than it raises in taxation. Some people in Australia say that it is ''wrong'' for Australian firms and individuals to invest overseas. The Overseas Sector Australia has an ''open'' economy. it helps to increase production and employment within Australia. However. as the income received from the sale of exports returns to our own domestic (local) economy. and the states have limited taxing abilities. thus attracting business to the east. the initial investment is a leakage from our economy. National income will tend to rise. There has been a net leakage from our circular flow. and large areas of health care. An increase in imports will see our national income fall. An increase in exports increases our national income. About 20% of all our total consumption is made up of goods and services produced overseas. Allowing each state to set its own taxes would encourage competiton between the states. for example on primary and secondary education. this ''profit repatriation'' is a leakage from our economy. is greater than the amount of money flowing into to our economy (X). If the Federal Government spends as much as it receives in taxation.

leakages are actions that slow down the rate of movement of resources and income through the circular flow of our economy. In ''four sector'' model of our economy. 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. Production and income will fall. We can now add the other ''leakages'' and ''injections'' mentioned above into our model. and investment by firms. made up of investment by firms and leakages were savings by households. Actions that increase the flow of income and resources within our economy include government spending. and so is taxation and expenditure on imports. If leakages (the variables on the left hand side of this equation) are. Exports add to our income. 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 .A deficit on the Balance of Payments will tend to reduce national income. as you will recall. . greater than the injections (the variables on the right hand side). employment and production reached an equilibrium when injections of funds into the economy equals the leakages.T is the government's Budget deficit or surplus. Injections were. A surplus on the Balance of Payments is a net injection into our circular flow. employment and production. and also are an injection. Saving is a leakage. then the economy will tend to ''contract''. and unemployment will rise. in total. In the two sector model of the 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 . the demand for our exports (''X''). less spending on imports (''M''.Defining Aggregate Demand We can use the model to help us define further concepts. demand for goods and services arises from the consumption decisions of households (''C''). In our economy. because the goods and services demanded are not produced in our domestic economy). the investment decisions of firms (''I''). the spending by Government(s) (''G'').

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