BBM-ME-II

MODULE – A
Macroeconomic Environment
of Business
Overall Level of Economic
Activity
& Circular Flow of Income
Prof. (Dr.) D N Panigrahi
Model
PhD (Finance), MBA (Fin-FMS, DU), CFA & MS-Finance, CAIIB & DFS, M.Sc. (Physics)
 Level of Overall Economic (Business) Activity
And Circular Flow of Income Model
In this slide we will discover how economists measure an
economy’s total output and income, as well as growth in
output and income.
We now turn to the question of what determines the overall
level of business activity. One of the most important
determinants, at least in the short run, is the level of spending
on firms’ output. The more consumers spend, the more firms
will want to produce in order to meet that consumer demand.
 Circular Flow of Income Model in a Closed Economy
with No Government & No Financial Markets
 Describe, using a diagram, the circular flow of income between households
and firms in a closed economy with no government & no financial markets.
 Identify the four factors of production (resources) and their respective
payments (rent, wages, interest and profit) and explain that these constitute
the income flow in the model.
 Outline that the income flow is numerically equivalent to the expenditure
flow and the value of output flow.
 The circular flow of income model illustrates a number of concepts and
relationships that will help us understand the macroeconomy. In its simplest
version, shown in Fig. 8.1, the model illustrates a closed economy,
meaning it has no links with other countries (it is ‘closed’ to international
trade), and is also a model of an economy with no government and no
financial markets.
 Fig 8.1 - Circular Flow of Income Model in a Closed
Economy with No Government & No Financial Markets
 Circular Flow of Income Model in a Closed Economy
with No Government & No Financial Markets
 It is assumed that the only decision-makers are households (or
consumers) and firms (or businesses): a two-sector economy; both
are shown in square boxes. Households and firms are linked together
through two markets: product (goods) markets and resource (factors)
markets, shown in diamonds.
 Households are owners of the four factors of production: land, labour,
capital and entrepreneurship. Firms buy the factors of production in
resource markets and use them to produce goods and services. They
then sell the goods and services to consumers in product markets. We
therefore see a flow in the clockwise direction of factors of production
from households to firms, and of goods and services from firms to
households.
 Circular Flow of Income Model in a Closed Economy
with No Government & No Financial Markets
 In the counterclockwise direction, there is a flow of money used as
payment in sales and purchases. When households sell their factors of
production to firms, they receive payments taking the form of rent (for
land), wages (for labour), interest (for capital) and profit (for
entrepreneurship).
 These payments are the income of households.
 The payments that households make to buy goods and services are
household expenditures (or consumer spending).
 The payments that firms make to buy factors of production represent their
costs of production, and the payments they receive by selling goods and
services are their revenues.
 All payment flows, known as money flows, are shown in Fig. 8.1
 Circular Flow of Income Model in a Closed Economy
with No Government & No Financial Markets
 This model demonstrates an important principle: the income flow from
firms to households is equal to the expenditure flow from households to
firms.
 In other words, the household incomes coming from the sale of all the
factors of production equals the expenditures by households on goods and
services. This is the circular flow of income.
 In addition, these two flows must be equal to the value of goods and
services, or the value of total output produced by the firms, known as the
value of output flow. The reasoning of this is as follows: if each good and
service is multiplied by its respective price, we obtain the value of each
good and service, and adding them all up we arrive at the value of total
output. This value is the same as consumer expenditure, since spending by
consumers is equal to each item they buy multiplied by its price.
 Circular Flow of Income Model in a Closed Economy
with No Government & No Financial Markets
 Therefore: The circular flow of income shows that in any given time period
(say a year), the value of output produced in an economy is equal to the
total income generated in producing that output, which is equal to the
expenditures made to purchase that output.
 Hence, Factor Income Flow = Household Expenditure Flow = Value of
Output Flow
 Factors of Production (Resources): [Land, Labour, Capital and
Entrepreneurship]
 Payment by Firms = Consumers’ Income = [Rent, Wages, Interest and
Profit]
 Circular Flow of Income Model in an Open Economy
with Government & Financial Markets
 Adding two more sectors (Government and Foreign Sector) including
Financial Markets and Adding Leakages and Injections
 Describe, using a diagram, the circular flow of income in an open
economy (= Foreign Trade) with government and financial markets,
referring to leakages/withdrawals (saving, taxes and import expenditure)
and injections (investment, government expenditure and export revenue).
 The real-world economy is more complicated than this simple closed two-
sector model suggests. We arrive at a closer picture of the real world by
adding two more sectors (the Government and the Foreign Sector including
Financial Markets) and also adding injections and leakages (also known as
withdrawals) to the money flow of Fig. 8.1.
 Circular Flow of Income Model in an Open Economy
with Government & Financial Markets
 To understand what these are, consider a pipe with water flowing
through it, as in Fig. 8.2. As water flows through the pipe, some leaks
out (the leakages), while new supplies of water are injected in (the
injections). It is the same with the flows of money in the circular flow
model.
 Leakages and injections are paired together so that what leaks out of
the flow can come back in as an injection. The most important pairs
are the following:
leakages injections
saving (S) investment spending (I)
taxes (T) government spending (G)
imports spending (M) exports spending (X)
Fig. 8.2 - Leakages and injections
 Circular Flow of Income Model in an Open Economy
with Government & Financial Markets
 Saving and Investment Spending: Saving is the part of consumer income
that is not spent but is saved. Investment is spending by firms for the
production of capital goods (physical capital), which is one of the four
factors of production. This is why capital goods are also known as
producers’ goods or productive capital.
 How are saving and investment linked together as leakages and
injections? When households save part of their income, this represents a
leakage from the circular flow of income because it is income that is not
spent to buy goods and services. Households place their savings in
financial markets and with financial institutions (bank accounts, purchases
of stocks or shares and bonds or debentures, mutual fund units etc.).
 Circular Flow of Income Model in an Open Economy
with Government & Financial Markets
 Business Firms obtain funds from financial markets and financial
institutions (through borrowing, issuing stocks and bonds, etc.) to finance
their investment expenditure, or the production of capital goods. These
funds therefore flow back into the expenditure flow into the economy as
injections.
 This process is shown in Fig. 8.3 below, which, in addition to the money
flows of Fig. 8.1, shows the three leakage/injection pairs as above. (For
simplicity, this figure contains only money flows.)
 Leakages appear in the left-hand side of the figure, and injections on the
right. We can see that saving leaks out of the flow of consumer
expenditures, and after passing through financial markets and institutions is
injected back into the expenditure flow as investment.
Fig. 8.3 – Circular Flow of Income Model
With Leakages & Injections
Fig. 26.8 – The Circular Flow of Income Model
in a 4-Sector Open Economy
Fig. 17.1 – The Circular Flow of Income Model
in a 4-Sector Open Economy
 Circular Flow of Income Model in an Open Economy
with Government & Financial Markets
 Taxes and Government Spending: Taxes and government spending are
connected to each other through the government. Households pay taxes to
the government; this is a leakage because it is income that is not spent to
buy goods and services. The government uses the tax funds to finance
government expenditures (on education, healthcare, defence, etc.) and this
spending is an injection back into the expenditure flow.
 Pause for thought: How would a rise in government benefit payments, all
other things being equal, affect the flow of withdrawals?
 Imports and Exports: Imports are goods and services produced in other
countries and purchased by domestic buyers. Exports are goods and
services produced domestically and purchased by foreigners. When an
economy has international trade through imports and exports, it is known
as an open economy.
 Circular Flow of Income Model in an Open Economy
with Government & Financial Markets
 Imports and exports are linked together through ‘other countries’ aka “rest
of the world (RoW)”.
 Imports are a leakage because they represent household spending that leaks
out as payments to the other countries that produced the goods and
services.
 Exports are an injection because they are spending by foreigners who buy
goods and services produced by the domestic firms.
 Summary: Leakages = Money that leaves the Circular Flow of Income
 Injections = Money that enters the Circular Flow of Income
 Pause for thought: 1. If injections exceed withdrawals, will GDP go on
rising indefinitely, or will a new equilibrium be reached? If so, explain how.
(We answer this in the next section.)
 2. What will be the effect on each of the key macroeconomic variables if
planned injections are less than planned withdrawals?
 Total Leakages (Withdrawals) –Vs- Total Injections

 Total withdrawals (leakages) are simply the sum of net saving, net taxes
and the expenditure on imports: Withdrawals (W) = Net Savings (S) + Net
Taxes (T) + Import Expenditure (M), or, W = S + T + M.
 Note that netting is done in respect of Savings and Taxes. Why?
 In Net Saving, we seek to measure the net flow from households to the
banking sector. We therefore have to subtract from saving any borrowing
or drawing on past savings by households in order to get the net saving
flow. Of course, if household borrowing exceeded saving, the net flow
would be in the other direction; it would be negative.
 So, Net Saving (S) = Current Saving – Any Borrowing or Drawing on
Past Savings
 Total Leakages (Withdrawals) –Vs- Total Injections

 Likewise, Net Taxes (T) = Total Taxes Paid by Households & Firms –
Transfer Payments (Benefits received from Govt. like Subsidy/Child &
Unemployment Benefits/ Pensions etc.) = Represents the net flow to the
government from households and firms.
 Benefits are known as transfer payments because money is transferred
from one group (e.g., government) to another (the recipients) without any
production taking place.
 Injections: Only part of the demand for firms’ output (aggregate demand)
arises from consumers’ expenditure. The remainder comes from other
sources outside the inner flow. These additional components of spending
are known as injections (J). There are three types of injections as already
discussed:
 Total Leakages (Withdrawals) –Vs- Total Injections

 Investment (I): This is the flow of money that firms spend which they
obtain from various financial institutions & markets– either past savings or
loans, or through a new issue of shares or bonds.
 They may invest in plant and equipment or may simply spend the money
on building up stocks of inputs, semi-finished or finished goods. Note that
we exclude from investment any money that is spent on imported
components, equipment, etc. As this money flows abroad it is counted as an
import (M).
 Total Leakages (Withdrawals) –Vs- Total Injections

 Government expenditure (G): When the government spends money on

goods and services produced by domestic firms, this counts as an injection.
Examples of such government expenditure are spending on roads, hospitals
and schools.
 Note that government expenditure in this model does not include state
benefits. These transfer payments, as we saw above, are the equivalent of
negative taxes and have the effect of reducing the T component of
withdrawals.
 It also excludes any money spent on imported components. This is counted
as imports.
 Total Leakages (Withdrawals) –Vs- Total Injections

 Export expenditure (X): Money flows into the circular flow from abroad
when residents abroad buy our exports of goods and services. Note that, as
with the other two injections, only those parts of exports made in the
country should be counted. Any imported materials or components into the
exports should be deducted.
 Total injections are thus the sum of investment, government
expenditure and exports: J = I + G + X.
 The relationship between Withdrawals (Leakages) and Injections:
There are indirect links between saving and investment via financial
institutions & markets, between taxation and government expenditure via
the government (central, state and local), and between imports and exports
via foreign countries. These links, however, do not guarantee that S = I or
G = T or M = X.
 Total Leakages (Withdrawals) –Vs- Total Injections

 Take investment and saving. The point here is that the decisions to save and
invest are made by different people, and thus they plan to save and invest
different amounts. Likewise the demand for imports may not equal the
demand for exports.
 As far as the government is concerned, it may choose not to make T = G. It
may choose not to spend all its tax revenues and thus run a ‘budget surplus’
(T > G); or it may choose to spend more than it receives in taxes and run a
‘budget deficit’ (G > T), by borrowing or printing money to make up the
difference.
 Thus planned injections (J) may not equal planned withdrawals (W). But
if they are not equal, what will be the consequences?
 The Size of the Circular Flow of Income
in relation to the Size of Leakages and Injections
 Explain how the size of the circular flow of income will change
depending on the relative size of injections (J) and leakages (W).
 Though paired together, in the real world, leakages and injections are
unlikely to be equal, and this has important consequences for the size of the
circular flow of income.
 If a leakage (W) is greater than an injection (J), then the size of the
circular flow of income becomes smaller. Suppose saving (a leakage) is
larger than investment (an injection). This means that part of the household
income that leaks as saving into financial markets does not come back into
the flow as investment. The result is that fewer goods and services are
purchased, firms cut back on their output, they buy fewer factors of
production, unemployment increases (since firms buy a smaller quantity of
labour) and household income is reduced.
 The Size of the Circular Flow of Income
in relation to the Size of Leakages and Injections
 If a leakage (W) is smaller than an injection (J), the size of the circular
flow of Income becomes larger. Suppose spending on exports is greater
than spending on imports; then the expenditure flow increases since the
injection is larger than the leakage. Foreigners demand more goods and
services, firms begin to produce more by purchasing more factors of
production, unemployment falls (as firms buy a larger quantity of labour),
and household income increases.
 To Summarise: Leakages from the circular flow of income (saving, taxes
and imports) are matched by injections into the circular flow of income
(investment, government spending and exports), though these need not be
equal to each other. If injections are smaller than leakages, the income flow
becomes smaller; if injections are larger than leakages the income flow
becomes larger.
 Size of Leakages –Vs- Size of Injections
Relative Size of Leakages Impact on the Size of Circular Flow of Income
& Injections And its Economic Consequences
If Sum of the Injections > the == the Circular Flow of Income Grows Bigger, the Production of Goods &
Sum of the Leakages Services (National Output or GDP) Rises, Household Income & National Income
Rises, the Economy Grows, and Unemployment Falls, Inflation will Rise (as the
(Assuming that the economy extra demand drives up the price of goods and services more rapidly than would
is not at full capacity) have been the case - (the closer to full capacity, the greater the likelihood),
balance of payments will deteriorate, as import demand rises due to the higher
domestic incomes, and higher inflation makes imports relatively cheaper and
exports more expensive (less competitive)

If Sum of the Injections < the == the Circular Flow of Income Shrinks/becomes Smaller, the Production of
Sum of the Leakages Goods & Services (National Output or GDP) Falls, Household Income & National
Income Falls, the Economy is in Recession (there will be Negative Economic
(Assuming that the economy Growth), and Unemployment Rises, Inflation will fall and the Balance of Payments
is not at full capacity) will improve
 The Size of the Circular Flow of Income
in relation to the Size of Leakages and Injections
 We can relate the above to the business cycle.
 When the economy is experiencing:
• a “boom”, it will typically be characterised by high output,
low unemployment, high inflation and a current account
deficit (CAD)
• a “slump”, it will typically be characterised by low output,
high unemployment, low inflation and a current account
surplus.
 Test Your Understanding 8.1

 1 (a) What are the two markets shown in the circular flow model?
Provide examples of what is exchanged (bought and sold) in each of
these.
 (b) What are the three flows shown in the circular flow model?
 2 The circular flow model shows that households and firms are both
buyers and sellers simultaneously. How is this possible?
 3 What are the four factors of production, and what are their
respective payments?
 4 Use the simple circular flow model to (a) show the circular flow of
income, and (b) show the equivalence between factor income flow,
household expenditure flow and the value of output flow.
 Test Your Understanding 8.1

 5 (a) What are leakages and injections in the circular flow of

income? (b) Use the circular flow of income model to
illustrate how the three pairs of leakages and injections are
linked together.
 6 What is the difference between a closed economy and an
open economy?
 7 What happens to the size of the income flow when (a)
leakages are larger than injections, and (b) injections are
larger than leakages?
 Summary

 1. Business activity is affected by the level of aggregate demand.

Aggregate demand (AD) equals AD = Cd + J = Cd + I + G + X = or
AD = C + I + G + X - M.
 2. The circular flow of income model depicts the flows of money
income and expenditure round the economy. The inner flow shows
the direct flows between firms and households. Money flows from
firms to households in the form of wages and other incomes (like
rent, interest and profit), and back again as consumer expenditure on
domestically produced goods and services.
 3. Not all incomes get passed on directly round the inner flow. Some
is withdrawn in the form of saving; some is paid in taxes; and some
goes abroad as expenditure on imports.
 Summary

 4. Likewise not all expenditure on domestic firms’ products is by

domestic consumers (Cd). Some is injected from outside the inner
flow in the form of investment expenditure (I) by Business Firms,
government expenditure (G) and expenditure on the country’s
exports (X).
 5. Planned injections (J) and withdrawals (W) are unlikely to be the
same.
 6. If injections exceed withdrawals, GDP will rise. As a result,
unemployment will tend to fall and inflation will tend to rise. The
reverse will happen if withdrawals exceed injections.
 KEY TERMS

• Overall level of Economic Activity, Circular Flow of

Income Model, Closed Economy, Open Economy,
Two-Sector Economy Model, Four-Sector Economy
Model, Leakages (Withdrawals), Savings, Taxes,
Import Expenditure, Consumption/Consumer
Expenditure, Injections, Investment Expenditure,
Government Spending, Export Expenditure, National
Income & Output, Aggregate Demand, GDP
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