How the macroeconomy works

The Circular Flow of Income

Households & Firms

The Two Sector Model

 Households and Firms (two sector economy)
• A model where by firms hire the four factors of
production from households to produce goods and
services and in return for their work are paid in the
form of rent, wages, interest and profit.
• The flow of money and income is circular as:
o The income earned by households allows them to buy the goods and
services that are sold by the firms
o The firms use the factors of production to produce goods and services
o Households buy the good and services with money they have earned
working for the firms
o The money passes from firms and then back again.
 The Circular Flow of Income
• The flow of money and
Households Payment
Of
income is circular as:
factors o The income earned by
£10m
households allows them to buy
the goods and services that are
sold by the firms
o The firms use the factors of
production to produce goods and
services
o Households buy the good and
Payment services with money they have
for goods
and services earned working for the firms
£10m Firms o The money passes from firms and
then back again.
 Equilibrium
• An economy is said to be in equilibrium when
the amount factors are paid is all spent on
the good and services produces by domestic
firms.
• In the above example:-
Payment Payment
Of for goods
factors and services
£10m £10m
(firms) (households)
 disequilibrium

• In reality households do
not spend all of their
income on products and
firms do not spend all
their revenue hiring labour
 Withdrawals/Leakages from the circular flow
Withdrawals
 Any money not
Households S
Payment passed on in the
Of
factors circular flow.
£10m
 Household savings
 Firms retained
profit.
 Withdrawals have
the effect of
Payment reducing national
for goods
and services income/output/expe
£10m Firms nditure
Withdrawals
S
 Disequilibrium – households saving a
percentage of their income

Payment
for goods
and services
Payment
£9m
Of
(households)
factors
£10m
(firms)

The reduction of payments for services causes a

contraction of the economy. Equilibrium may be restored
by firms reducing payment for factors (reduced wages,
production and or unemployment ). National
income/output/expenditure is now only £9m
Disequilibrium – firms retaining profit for
the future

Payment
Of
factors
£9m Payment
(firms) for goods
and services
£10m
(households)

The reduction in payments for factors causes a

contraction of the economy. Equilibrium is likely to be
restored by households spending less, a result of reduced
wages, production and or unemployment. National
income/output/expenditure is now only £9m
 Injections to the circular flow

 Money that originates

Households Payment outside the circular
Of
factors flow.
£10m
 Firms undertaking
investment spending
from retained profit of
borrowed funds.
 Injections have the
effect of increasing
national income
Payment
for goods
and services
£10m Firms /output/expenditure
Injections
I
 Disequilibrium – firms undertaking
investment spending

Payment
for goods
and services
Payment
£10m
Of
(households)
factors
£11m
(firms)

An increase in the payment for factors causes an

expansion of the economy. Equilibrium may be restored
by households increasing payment for goods and
services (increased wages, production and or
employment ). National income/output/expenditure is now
Government Expenditure &
Taxation
The Three Sector Model
 Injections to the circular flow
(government spending)
Injections
 G regarded as an injection
G Households Payment as it does not arise through
Of
factors
spending of households.
£10m
 G may benefit households
employed by the public
sector (more employment or
higher wages) or through
transfer payments.
 G may benefit firms
Payment
for goods
through the winning of
and services contracts or grants and
£10m Firms
subsidies.
Injections
I+G
Disequilibrium – governments undertaking
spending on new house building projects

Payment
for goods
and services
Payment
£10m
Of
(households)
factors
£11m
(firms)

An increase in the payment of factors causes an

expansion of the economy. Equilibrium may be restored
by households increasing payment for goods and
services (increased wages, production and or
employment ). National income/output/expenditure is now
 Withdrawals/Leakages from the circular flow
(government taxation)
Withdrawals
 T affects both households and
Households S+T firms.
Payment
Of
 T has the effect of reducing the
factors amount both have to spend.
£10m
 Important to understand the
government’s net position or
FISCAL STANCE i.e. does it plan to
spend more than it receives in
taxes?
 The Budget delivered by the
Central Government outlines the
government’s plans regarding
Payment Taxation and spending for the
for goods forthcoming year.
and services
£10m Firms

Withdrawals
S+T
 Equilibrium (recap so far)
• An economy is said to be in equilibrium when

planned injections = planned withdrawals

I+G S+T

Where planned injections are greater than planned withdrawals,

the effect on the circular flow is expansionary.
Exports & Imports

The Four Sector Model

(The open economy)
 Injections to the circular flow (exports)
Injections
 X are considered an
G+X Households Payment
Of injection for they
originate outside the
factors
£10m

circular flow.
 They have the effect of
increasing national
income.
Payment
for goods
and services
£10m Firms

Injections
I+G+X
Disequilibrium – an increase in demand for
domestically produced goods/services
abroad

Payment
Of
factors
£10m Payment
(firms) for goods
and services
£11m
(households)

The increase in payment for goods and services abroad

causes disequilibrium in the economy. Equilibrium is
likely to be restored by an increase in the payment of
factors a result of higher wages, production and or
employment. National income/output/expenditure is now
£11m
 Withdrawals/Leakages from the circular flow
(imports)
Withdrawals

Households S+T+M  M represents money

Payment
Of
factors
leaving the circular
£10m
flow.

Payment
for goods
and services
£10m Firms

Withdrawals
S+T+M
 In summary
• An economy is said to be in equilibrium when

planned injections = planned withdrawals

I+G+X S+T+M
 Disequilibrium and the effect on the
circular flow (national income)
• An economy is said to be in disequilibrium when:-
planned injections > planned withdrawals
Or
planned injections < planned withdrawals

S+T+M I+G+X

I+G+X S+T+M

Expansionary effect on the Contractionary effect on

circular flow (increased the circular flow (reduced
national income) national income)
 The circular flow of Income
(The Four Sector Model)
Injections Withdrawals

G+X Households S+T+M

Payment
Of
factors A simple economic
model which
£10m

describes the
reciprocal
circulation of
Payment
income between
for goods
and services producers and
£10m Firms
consumers
Injections Withdrawals
I +G + X S+T+M