Ba 1 Chapter 9

CIMA BA1 Study Text
Chapter 9
Circular Flow of Income and

Monetary Policy
Chapter 9 Circular Flow of Income and Monetary Policy
1. Microeconomics vs macroeconomics
Have you ever been studying something and started to wonder what impact it really has
on your life? Well, economics does impact all our lives because it affects how the
country is run and how wealthy the country is. The wealthier the country, the wealthier
its people. If the economy is poorly run, the people suffer.
Over-borrowing by the Greek government up to the 2008 financial crisis sent the
country's economy into meltdown. Between 2008 and 2012 the Greek economy fell by
16% - public services were cut, unemployment rose significantly and the country went
into a political crisis.
Microeconomics
Quick reminder! You may remember that economics is all about how resources are
allocated; how individuals and firms make decisions regarding their resources (cash,
people, assets etc.). For example, the factors affecting our decisions as to what we will
spend our money on, the decisions a business makes about using the staff it has
employed, or the decisions regarding how a Government will spend the taxation revenue
that it has collected. The difference between macro and microeconomics is
dependent on who is doing the allocating.
Previous sections looking at demand, supply and markets will fall under the
microeconomics umbrella as these allocation decisions are being made by firms,
employers, employees and individuals. The next few chapters will be moving on to
look at macroeconomic issues.
Macroeconomics
When we turn to macroeconomics we are thinking big. Those big sweeping influences
which affect all of us, such as inflation, unemployment and economic growth
(definitions coming up). As such, the economy can be influenced by the government
but is largely out of the control of the individual or the business.
In our example of the Greek economic crisis, those were macroeconomic decisions gone
wrong as it related to economic decisions for a whole country made by governments.
In macroeconomics the economy is made up of:
• production (what gets made and bought e.g. producing a car)
• consumption (what gets used or consumed e.g. eating food, or going to a

football match)
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• income (also called the money supply).
2. The circular flow of money

A simple economy
In Land of Plenty, there was one business, Sell Everything Ltd, that made and sold
everything. Whatever you needed they had it! But they didn’t only sell everything you
could ever want; they were also the only employer, and they were so enormous that
they employed everyone!
What was the outcome of this situation? Well, let’s take Steve: Steve works for Sell
Everything Ltd and is paid by them at the end of the month. Steve, seeing his salary in
his bank account, then goes to the Sell Everything Ltd’s shop and buys everything he
needs, using up all his money by the end of the month. In Steve’s world the flow of
money in the economy is represented by the diagram below.
Here we can see how the arrow marked ‘Labour’ shows Steve’s labour, the work Steve
does for Sell Everything Ltd at his job. The goods and services arrow represents
everything Steve spends his income on in Sell Everything Ltd’s shop.
The outside arrows demonstrate that Steve’s income comes to him from Sell Everything
Ltd and then returns to Sell Everything Ltd as Steve spends it all in their shop. Nothing
extra comes in or goes out, so all the money keeps going round and round.

The total size of the economy is measured using what is known as the aggregate
demand – which in this case is all the spending by Steve in the year.
Multiple households and businesses

Of course there is usually more than one person in an economy, and more than one
company, so a more generic model looks like this:
In this model we can see that instead of just Steve we have “households” (people) and
instead of Sell Everything Ltd we have businesses.
Most households have one or more earners who work at a business in exchange for
getting paid, which is depicted by the lowest arrow, showing how businesses provide
income for households. The labour (people doing their jobs) is used by the businesses to
make products which are then bought by the households. The top arrow shows how
households spend their income at a business to gain these products.
As we can see from the diagram, the income that is earned is effectively returned to
businesses as people spend it on goods and services so that the money goes round and
round from businesses to households.
The total size of the economy is measured using the aggregate demand – which in this
case is all the spending by the households in a period of time.

Withdrawals
This simple version of the model therefore shows that expenditure equals income -
always! No extra money ever enters or leaves the system.
That's not true in the real world though. Some of us try not to spend everything we earn
each month and businesses are just the same - after all, they want to make a profit!
So back to our example. What if Steve decides to put some money in his bank account to
save for the future? The money does not simply return to the business, and we have a
leak! This is known as a withdrawal. A withdrawal is money being taken out of the
economic flow of funds.
Funds can leave the economic flow through:
• saving (where the funds will sit unspent in the bank)
• taxes (where the funds go to the government)
• buying a product from overseas (where the funds go to that country)
Injections
Of course, some people spend more than they earn each month too. Let's say Steve
decides to borrow some money – say to pay for a new car. By spending more money in a
business than he has earned from the business Steve has added extra money into the
economic flow of funds. This is known as an injection. Injections are amounts of money
entering the circular flow of funds.
Funds can enter the economy through:
• borrowing (money from bank enters the flow)
• government spending (e.g. a new road or hospital)
• selling a product overseas (when the funds come in from the country the product
is sold to).
How governments aim to manage economic growth

As we've seen the total size of the economy is measured by the total amount spent (the
aggregate demand).
Growing the economy
If governments want to grow the economy they can do so by injecting more money
into the flow of funds (e.g. by spending money on a new road or school, or by making

borrowing easier or cheaper.) They can also reduce the amount withdrawn from the
economy (e.g. reducing taxes) keeping more funds flowing around and around increasing
the total amount spent.
Slowing economic growth
Similarly if the government feel the economy is growing too quickly (yes that can be the
case as we'll see later) they can slow its growth by increasing the size of the
withdrawals (e.g. by taxing more) or reducing the injections (e.g. by spending less).
Summary
So as you can see, macroeconomics can always be related back to the flow of funds
around an economy. The greater the flow the larger the economy. Governments control
that flow by controlling the injections or withdrawals from the economy.
We'll learn more about the different types of injection and withdrawal in the next few
sections. The first of these is savings and investments...
3. Savings and investments

Time to take a look at these amounts sneaking in and out of our economy ...
Savings
The first type of withdrawal that we’re going to look at is savings. This can be through
such things as bank or building society accounts, but also, Steve may just have hidden it
under the bed, or in a sock! Therefore, the definition of savings is any amount of
income that is not spent.
Factors affecting savings

There are several factors which determine how much people save, which we will
examine now:
The interest rate
The interest rate is the amount of money banks (or other institutions) pay you for
leaving money in one of their accounts. It’s usually paid annually. If the interest rate
was to rise, it becomes more attractive to save money because savers will receive a
larger interest payment.
Income and job security
If people are confident about receiving future income, they may save less and vice
versa. If Steve is in a long term secure job he can happily spend everything he earns. If

he's worried he may be made redundant he may start saving in anticipation of losing his
job.
Level of income will also play a part. Those earning more will have more disposable
income (income above the level of their outgoings) and will therefore be able to save
more. Someone only earning enough to cover their bill will not be able to put much
money into savings!
Availability of credit
If credit e.g. loans from banks or amounts available on credit cards etc. is easy and
cheap to obtain people may choose to not to save for future purchases or in case or
emergencies, as money is readily available.
Contractual saving
Some people may enter agreements through which they are contracted to save specific
regular amounts e.g. through pension schemes. The take up of these financial
products will contribute to the level of saving in the economy.
Tax relief
Some kinds of saving bring about benefits in the form of tax relief e.g. employees saving
into a pension in the UK receive tax relief where they get the tax they’ve already paid
reimbursed. If the levels of tax relief rise on these products, the level of savings
through them may also rise.
Inflation
Inflation is the amount prices rise over time. The amount of goods and services that
we can buy with our money is known as its real value. The effect of inflation (when
prices rise) is to reduce the real value of our money, because when prices rise we can
now buy fewer goods and services than before, even if we have the same amount of
money.
For example, say inflation is running at 5% per annum and you earn £1,000 a month -
which you spend in full. By the end of the year, inflation means that the prices of the
same products you currently buy will have risen to £1,050.
Unless you’re earning more you’ll need to leave some of the goods you previously bought
on the shelves! The real value of your earnings (the amount you can buy with it) has
therefore fallen by £50.
How does this affect interest rates? Well, although the interest rate may be high (e.g.
5%), so might inflation (e.g. 9%). Here, your money in your bank account is growing at
5% over the year, but the prices of everything you may want to buy with it are growing
at 9%. In this scenario savings don’t look very attractive and will fall.

Investments
The majority of savings will go through some kind of financial intermediary e.g. a bank,
building society or pension fund (rather than in a sock or under the bed!) People and
firms will also use these financial institutions to borrow money to make investments.
This is the first type of injection that we’re going to consider.
So what constitutes an investment? Well it can be:
• capital items: an individual buying a car or a business buying new machinery.
• increase in inventory: the stock of raw material, work in progress or finished

goods for businesses.
Factors affecting investment

The following are the main factors affecting the level of investment:
New or replacement investment
How much is actually new investment and how much is just being undertaken to replace
things that have got broken or worn out?
New investment will potentially grow the economy whilst replacement investment just
keeps everything at the level it is now.
There is an increase in investment when net investment is positive:
Net investment = New investment – replacement investment
Expected future returns
The higher the income that an investor may receive in the future as a return from their
investment the more they will be encouraged to invest.
Business confidence
If business owners are uncertain about the future they may well defer their investment
decisions until a later date.
Interest rates
If interest rates are high then interest payment on any savings will be high. High interest
rates will encourage saving rather than investment, while also making it very expensive
to borrow to invest.
Government policy

Actions of the government can change investment amounts e.g. tax breaks on
investments made.
Flow of funds with savings and investments

If we take into account savings and investments, how does our flow of funds diagram
look?
The above shows that not all the income that comes from the businesses to households
is used to buy goods and services. Some of it flows out in savings, and back in as
investments.
What happens is one is bigger than the other? Well, if injections are greater, then the
national income (the total amount of goods and services produced over the course of
a year which is equal to the total amount earned by all people and businesses) will
rise and vice versa if withdrawals are greater. Savings and investments aren’t the only
injections and withdrawals, but before we go on to look at other injections and
withdrawals we’re going to take a little break to consider consumption.
Managing economic growth using savings and investments

As a reminder, the total size of the economy is measured by the total amount spent
(the aggregate demand). The more money that enters the flow, the higher the growth.

Growing the economy
If governments want to grow the economy they can do so by injecting more money into
the flow of funds. One way they can do this is to encourage borrowing and subsequent
investment. If the government wants to encourage borrowing they can reduce interest
rates so borrowing is cheaper, or they can reduce any government restrictions on
borrowing.
Another way the government can grow the economy is by reducing the amount
withdrawn from the economy. This could be by reducing interest rates, which
discourages people from saving.
To encourage economic growth the government could also make it easier for banks to
lend e.g. they could decrease the amount of money (reserves) that banks are required
to keep relative to the level of loans or investments that they are undertaking, so banks
can lend more.
Slowing economic growth
Similarly if the government feel the economy is growing too quickly they can slow its
growth by increasing the size of the withdrawals by increasing interest rates,
encouraging people to save more and borrow less.
The government could also make it more difficult for banks to lend e.g. they could
increase the amount of money (reserves) that banks are required to keep relative to the
level of loans or investments that they are undertaking so banks can lend less.
Monetary policy
Monetary policy is one approach to managing an economy by a government.
The most commonly used tool of monetary policy is increasing or reducing interest
rates to increase or reduce the money in the circular flow of income, and hence grow or
slow the economy.
Making lending easier or harder is also a popular monetary policy tool.

Interest rates
As we've seen, changing interest rates is a key element of monetary policy. However, as
well as affecting the level of spending and saving in the economy, altering interest rates
can also have other effects.
Rising interest rates will typically have the following impacts on an economy:
Impact Explanation
Decreased Borrowing is more expensive and so companies and

investment individuals borrow less.
Attraction of As interest rates rise overseas investors may save in

foreign funds that country to capitalise on the higher returns.
Due to the inflow of funds into the economy from

Effects on the
overseas, the demand for currency increases which will
exchange rate
increase the exchange rate.
A rise in interest rates will discourage spending and

Decreased
investment and reduce demand in the economy,
inflation rate
therefore reducing the pressure on prices.
Decrease in Assets which depend on the interest paid for their value
asset value (corporate or government bonds) may fall in value.
Any sales for which the consumer needs to borrow

Affect on sales
funds will be likely to fall.
Obviously, the reverse of the above would be true if interest rates were to fall.
4. Imports and exports

How else can money find its way into the economy or leak out? In our diagram so far we
have assumed that everything we buy will be made and sold within the same country -
but we know this doesn’t happen in real life! If something is made and sold in another
country, payment for that good will go back to that country e.g. it will be an outward
flow of funds.
Alternatively, if something made in a home country is sold to someone in another

country, the money will enter the home economy as an injection.
So our circular flow diagram will look like this:

The amounts flowing into and out of the economy by way of imports (when a product is
purchased from overseas) and exports (when a product is sold overseas) are recorded
in the balance of payments.
Balance of payments
In very simplistic terms this looks at the value of imports and exports and the
difference between them. When we import goods and services, the money we use to
purchase these goods and services flows out of the country to the suppliers overseas.
Conversely, if we export goods and services, money flows into the country as overseas
customers are paying us. It's useful to think of it in terms of a bank account - actually
three: a current account, a capital account and a financial account.

Most of the constituents of these accounts are quite clear, but reserve assets might need
a little more explanation:
Reserve assets
Reserve assets are assets held by governments in reserve. Governments hold items like
gold and foreign currencies. In 2016 for example, China held reserves of foreign
currencies totalling US$3.12 trillion. When they buy or sell those reserves, changes are
shown in the financial account.
Balancing item
The balance of payments is set up such that over all three accounts the total must
equal zero. This is achieved by using a balancing item.
In total:
Current Ac. + Capital Ac. + Financial Ac. + Balancing item = 0
Once all the other accounts are fully recorded the difference is known as the balancing
item.

Balance of payments and economic growth

Remember the rule – an inflow of funds into the economy grows the economy, while
an outflow slows growth. Exporting brings money from other countries into the
economy which therefore causes growth, while importing sends money out of the
economy as goods are bought from overseas, which slows growth.
Overall, if exports are greater than imports, the current account is in surplus,
resulting in a net inflow into the economy, growing the economy. If more money is
flowing out of the country than coming in i.e. a net outflow, there will effectively be
less money available for us to spend, use to make products or pay workers etc. We'll see
the economy shrink.
Imbalance in the current account

The area of main concern with the balance of payments is if the current account is
consistently in deficit. This means that we are buying more from countries abroad than
they are buying from us and hence there is more money going out than coming in (bit
like having a permanent overdraft situation on your bank account). How does this
happen? There are two main considerations:
Import penetration
This is basically the extent to which imports are increasing. It can occur for several
reasons:
• Exchange rate changes making overseas products appear cheaper e.g. if the
exchange rate of the $ to the £ was 2:1, a mobile phone priced at $100 would
cost £50, if the $ fell in value so that the exchange rate was now 3:1, the mobile
phone would now cost £33 making more people buy from the US.
• Imports being more competitive on price e.g. low prices of goods from China
encouraging Chinese imports.
• Imports being more competitive on non-price factors e.g. design, after sales
service and reliability.
Export performance
The reverse of import penetration is export performance, the extent to which exports
are being sold. It is affected by similar things:
• The exchange rate e.g. in the example above the exchange rate makes the UK
goods less competitive and exports would fall.
• Price and non-price competitiveness against import suppliers e.g. less

competitive means fewer sales.

• Willingness and ability of domestic producers to export. This may depend on

spare capacity being available to produce an amount above that required by the
domestic market.
How can governments manage the balance of payments?

So how do we correct any imbalances in trade?
Do nothing
Perhaps surprisingly, doing nothing is a valid option.
As we have discovered above one of the main factors that affects the level of exports
and imports is the exchange rate as movements here change the price paid by the
consumer.
If the exchange rate is allowed to move freely it is thought that it will naturally move
to correct any imbalances.
For example: what if imports to country A are greater than its exports? In this case more
money will be flowing out of the country than flowing in. In order to buy these imports
people will be selling the currency of country A in order to buy the currencies needed to
pay for their imports. There will therefore be a greater supply of currency than demand
for it. And what happens when supply is greater than demand? The price falls in order to
make the surplus more attractive to buy. So the value of the currency of country A will
fall, making imports dearer and exports cheaper, until hopefully equilibrium is reached.
However, due to many other external factors, this mechanism doesn’t always work
smoothly. So what else can we do?
Actively affect exchange rates
Governments can buy and sell currencies to make exchange rates more favourable.
China increased their foreign currency reserves by selling Yuan and buying other
currencies (mostly the US dollar) from $0.17 trillion in 2000 to £3.84 trillion by 2014.
One goal of this policy was to keep the value of the Yuan low and make its exports
cheap to help grow their economy.
Trade barriers
Governments can put up trade barriers to stop imports. These can include:
• High tariffs on imported goods
• Quotas which limit the number of imported goods to a certain level

Example
Which of the following would result in a net inflow of money as recorded on the current
account of the balance of payments:
1. Imports being equal to exports
2. Exports being greater than imports
3. Imports being lower in value than exports
4. Imports being greater than exports
Answer
These types of questions are always easy to slip up on as at first glance it’s hard to
distinguish between the answers!
1 – If imports and exports are equal, the overall balance is zero, neither a net inflow nor
a net outflow.
2 – Exports bring more money in as customers abroad pay for them. Therefore, if exports
are greater than imports, this will represent a net inflow.
3 – In this statement, exports are higher in value than imports, so a net inflow of money.
4 – This is the reverse of the above, imports are greater then exports, so an overall
outflow of money.
The correct answers are therefore 2 and 3.
Monetary policy
So we saw in the previous section that monetary policy included:
• Changing interest rates
• Making borrowing and lending easier or harder.
Our strategies to actively affect the levels of imports and exports can now be added to
this:
• Buying and selling currencies to change foreign exchange rates
• Imposing or removing trade barriers to make foreign trade easier or harder.

We can now return to our income flow diagram and see the areas covered by monetary
policy:
5. Money
As we have seen monetary policy aims to alter and control the supply of money as a
means to tackle issues facing the economy.
There are in fact many different measures of money, but the two most important are:
M0 – Notes and coins in use and amounts within accounts held at the central bank
(e.g. in the UK the Bank of England or the US the Federal Reserve). Referred to as
narrow money within the UK.
M4 – Notes and coins within circulations and all private sector bank accounts. Referred
to as broad money in the UK.
Money supply and interest rates

If the government reduces the money supply by borrowing more funds (and not
spending them) this means there is less money in circulation. As supply has gone down
banks can charge more for it through higher interest rates. It's the same idea as prices
of goods goes up when the supply of products goes down.

If the government pays back its debt the interest rates are likely to fall for the opposite
reasoning.
Example
The government decide to decrease the money supply. What effects will this have on
interest rates and investment?
1. An increase in interest rates and investment
2. A decrease in interest rates and investment
3. An increase in interest rates, but a decrease in investment
4. A decrease in interest rates, but an increase in investment
Answer
Reducing the money supply means there is less of it in circulation. As supply has gone
down banks can charge more for it through higher interest rates. When interest rates
rise, it becomes more expensive to borrow funds and so we would expect investment to
fall. Our answer is therefore 3.
6. Consumption
We’ve seen that not all the money may stay in the economic system due to such things
as savings and investments. We also now understand that there are factors which will
affect the level of those injections and withdrawals such as interest rates.
Of course, if injections and withdrawals go up and down, so will consumption – the

amount of goods and services demanded in the economy. e.g. if I save more, I have
less to spend on goods and services.
Let's examine the range of factors affecting consumption.
Income
The number one factor affecting consumption is income level. The general consensus
is that as income goes up, consumption goes up. There is a measure of this which is
the marginal propensity to consume or MPC and it is calculated as follows:
Change in consumption, (ΔC)

MPC =
Change in income (ΔY)
NOTE: Δ = change in amount (demonstrated in the example below)

Let’s look at an example!
Example
Let’s say that at the end of every week Steve receives £400 for his hard work and that
once he has paid his £280 bills he has £120 left over. This is known as his disposable
income. He spends £100 of this and puts £20 in his money box.
However, joy of joys, Steve’s boss gives him a pay rise, so that he now gets £430 a
week. After paying his £280 bills Steve now has £150 left over and of this, now spends
£120 and puts £30 in his money box. What affect does this have on his MPC?
Answer
Looking at Steve’s consumption first, this has increased from £100 to £120, so has gone
up by £20. His income in total rose from £400 to £430 or by £30. Putting this into the
formula above:
£20
MPC = = 0.6
£30
If we carried on measuring this for Steve as he got further pay rises in the future, we
would get a better idea of how changes in his income affect his consumption. We could
also take this a step further and work it out over the whole population, using changes in
total income and total expenditure, which would be of interest to governments when
developing policies.
Will MPC continue to rise as income rises? Generally it is assumed not, or at least that
the value will fall - there has to be a point where we just don’t need any more and our
consumption slows!
What other factors affect consumption?
Previous or future income

Whilst we have considered the effects of changes in current income on the level of
consumption, some people will be used to a certain level of consumption based on their
previous income levels, and will not feel the need to change it even though their
disposable income has risen. A rise in income for these people will therefore not lead to
a rise in consumption.
Alternatively, for others, just knowing that a pay rise is imminent may affect their
consumption levels. They may increase their spending in anticipation of the income that
they will soon have. For these people then, whisper the words ‘more money’ and you’ll
see consumption rise!

Windfall gains or losses

People may receive money unexpectedly through inheritance, winnings or gifts.
Alternatively, they may lose money through fraud, burglary etc. Depending on how
someone reacts to these situations their level of consumption may change. For example
those receiving windfalls may either choose to save it all for later or spend, spend,
spend!
Wealth
The level of wealth owned by an individual is thought to affect their consumption levels.
Wealth is defined as the market value of all assets less any amounts owed (assets are
generally valuable things such as a house, car, oil paintings, shares etc.). It is believed
that as this amount rises, someone’s consumption will also rise.
Government policy
Through their monetary policy governments have the ability to affect interest rates,
exchange rates in order to control the money supply in the circular flow. As we’ve
seen, these changes can alter the amount of money people have available to spend and
therefore impact levels of consumption.
Of course, the government can also change taxation levels, or decide to increase
public expenditure, which also influence the levels of consumption. We will look at
these shortly when we cover fiscal policy.


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CIMA BA1 Study Text

Circular Flow of Income and

In macroeconomics the economy is made up of:

• production (what gets made and bought e.g. producing a car)

• consumption (what gets used or consumed e.g. eating food, or going to a

© Astranti Financial Training 2020

• income (also called the money supply).

2. The circular flow of money

© Astranti Financial Training 2020

Multiple households and businesses

© Astranti Financial Training 2020

Funds can leave the economic flow through:

• saving (where the funds will sit unspent in the bank)

• taxes (where the funds go to the government)

• buying a product from overseas (where the funds go to that country)

Funds can enter the economy through:

• borrowing (money from bank enters the flow)

• government spending (e.g. a new road or hospital)

How governments aim to manage economic growth

Growing the economy

© Astranti Financial Training 2020

Slowing economic growth

3. Savings and investments

Factors affecting savings

The interest rate

Income and job security

© Astranti Financial Training 2020

© Astranti Financial Training 2020

So what constitutes an investment? Well it can be:

• capital items: an individual buying a car or a business buying new machinery.

• increase in inventory: the stock of raw material, work in progress or finished

Factors affecting investment

New or replacement investment

There is an increase in investment when net investment is positive:

Net investment = New investment – replacement investment

Expected future returns

© Astranti Financial Training 2020

Flow of funds with savings and investments

Managing economic growth using savings and investments

© Astranti Financial Training 2020

Growing the economy

Slowing economic growth

Monetary policy is one approach to managing an economy by a government.

Making lending easier or harder is also a popular monetary policy tool.

© Astranti Financial Training 2020

Decreased Borrowing is more expensive and so companies and

Attraction of As interest rates rise overseas investors may save in

Due to the inflow of funds into the economy from

A rise in interest rates will discourage spending and

Any sales for which the consumer needs to borrow

4. Imports and exports

Alternatively, if something made in a home country is sold to someone in another

So our circular flow diagram will look like this:

© Astranti Financial Training 2020

© Astranti Financial Training 2020

Current Ac. + Capital Ac. + Financial Ac. + Balancing item = 0

© Astranti Financial Training 2020

Balance of payments and economic growth

Imbalance in the current account

• Price and non-price competitiveness against import suppliers e.g. less

© Astranti Financial Training 2020

• Willingness and ability of domestic producers to export. This may depend on

How can governments manage the balance of payments?