CHAPTER II

THE CIRCULAR FLOW

OF ECONOMIC
ACTIVITY

TWO BASIC ACTIVITIES UNDERTAKEN:

1.Production perform by the firm
2.Consumption- undertake by
households

STOCK AND FLOW CONCEPTS

STOCK refers to the measure of quantity
at a point of time.
Example: an accumulation of a
commodity like gasoline in a fuel tank
FLOW refers to the measure of
movement of quantity over a period of
time
Example: income represents money
earned per year is a flow.

THE CIRCULAR FLOW OF GOODS AND

SERICES AND INCOME

THE PRODUCTION PROCESS- the process of

producing goods and services involves household
and firms in a circular flow.

FIGURE 1: THE CIRCULAR FLOW OF THE

PRODUCTION PROCESS
LAND, LABOR, CAPITAL
(Economic Resources)

HOUSEHOLDS
(Resource
Owners)

FIRMS
(Organizers and
users of Economic
Resources)
GOODS AND SERVICES
(Output)

FIGURE 2: THE FLOW OF OUTPUT BETWEEN

FIRMS AND HOUSEHOLDS

RAW MATERIALS
FIRM

INTERMEDIATE
GOOD FIRMS
Raw
materials
Intermediate
goods

FINAL GOODS
FIRM

HOUSEHOLDS
Final goods

 Raw Materials are goods which are still

unprocessed like wood, sand and iron ore.
Intermediate goods are partially processed
and still need further processing before they
can be finally consumed.
Final Goods are processed goods that are ready
for final consumption like cassette players,
candies and ready to wear clothing.

FIGURE 3: THE CIRCULAR FLOW OF GOODS

AND INCOME AMONG PRODUCERS AND
HOUSEHOLDS

HOUSEHOLDS

ECONOMIC
RESOURCES
PAYMENT
ECONOMIC
RESOURCES
PAYMENT
ECONOMIC
RESOURCES
PAYMENT
FINAL GOODS
PAYMENT

RAW
MATERIALS
PRODUCERS
INTERMEDIATE
GOODS
PRODUCERS
FINAL GOODS
PRODUCERS

INCOME FLOW
When money is spent by households for
consumption and firms for production, a
circular flow of income is created. The
expenditure of one unit becomes the
income of another unit.
TWO DISTINCT CIRCULAR FLOWS AS
FOLLOWS:
1. Between Households and firms, and
2. Between Firms

FIGURE 4: THE CIRCULAR FLOW OF

INCOME BETWEEN HOUSEHOLDS AND
FIRMS
INCOME FLOW
(Wages, interests,
rents)

HOUSEHOLDS
INCOME FLOW
(purchase of goods
and services)

FIRMS

FIGURE 4: THE CIRCULAR FLOW OF

INCOME BETWEEN FIRMS
RAW
MATERIALS
FIRMS

Income Flow for

purchase of raw
materials

INTERMEDIAT
E GOOD
FIRMS

Income Flow for

purchase of
intermediate goods

FINAL
GOODS
FIRMS
Income Flow for
purchase of final goods

HOUSEHOL
DS

FIGURE 6: THE EFFECT OF REDUCTION

OF PURCHASES
REDUCED INCOME
(as a result of reduced
purchases of economic
resources

HOUSEHOLDS
REDUCED INCOME
(as a result of reduced
purchases of goods
and services)

FIRMS

FIGURE 7: THE CIRCULAR FLOW OF

GOODS AND INCOME IN A SIMPLE
ECONOMY WITH SAVINGS AND
INVESTMENTS
FIRMS

RENT, WAGES,
INTEREST,
PROFIT

LAND, LABOR,
CAPITAL

GOODS AND SERVICES

Investment
s
Capital
goods

PAYMENT
S

HOUSEHOLDS
SAVINGS

GOVERNMENT
Land, labor capital

Payments for goods and services

Rent, wages, interest

Rent, wages, interest

HOUSEHOLDS

FIRMS
Goods and services
Payments for exports

payments for imports

Payments for goods and services

FOREIGN
COUNTRIES