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Circular_Flow_of_Income_1

The document explains the circular flow of income model, illustrating how money, goods, and services circulate between households, firms, and the government in both closed and open economies. It discusses the concepts of injections and leakages, detailing how these factors affect economic equilibrium and disequilibrium. The lesson aims to provide learners with a comprehensive understanding of these economic principles and their implications.

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6 views21 pages

Circular_Flow_of_Income_1

The document explains the circular flow of income model, illustrating how money, goods, and services circulate between households, firms, and the government in both closed and open economies. It discusses the concepts of injections and leakages, detailing how these factors affect economic equilibrium and disequilibrium. The lesson aims to provide learners with a comprehensive understanding of these economic principles and their implications.

Uploaded by

epiczebra18
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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The Circular Flow of Income

DANIEL JNR SOROGO


Lesson Objectives
At the end of this chapter, learner will learn how to:

 Define the circular flow of income


 Explain the difference between the circular flow of income in;
 A closed economy and in an open economy:
 The flow of income between households, firms and the government
and the international economy
 Analyze the impact of injections and leakages on the circular flow
of income
 Identify the difference between the country’s income being in
 Equilibrium and being in disequilibrium.
The circular flow

 The circular flow of income is a basic economy model that


depicts how money, goods, and services move between economic
agents.
 The circular flow model demonstrates how money moves from
producers to households and back again in an endless loop.
 In an economy, money moves from firms to workers as wages
and then back from workers to producers as workers spend
money on products and services
 Firms: companies that produce goods and pay wages to
employees.
 Households: individuals who receive wages from firms while
simultaneously purchasing the goods and services from the firms.
Circular Flow of Income Model
 The circular flow of income explains that output produced
generates income which is then spent on the output. This flow
explains why GDP can be measured by calculating the country’s
output, income and expenditure.
Closed Economy
 A closed economy typically refers to an economy that does not
trade or engage in other financial exchanges with any other
countries.
 This means that no imports come into the country and no
exports leave it. The goal of a closed economy is complete self-
sufficiency, providing domestic consumers with everything they
need from within the country's own borders.
 In today's interconnected world, closed economies are more of a
theoretical concept than a reality, although some economies are
more closed than others.
 In some open economies, governments may close off a specific
sector or industry from international competition through the use
of quotas, subsidies, and tariffs (protectionism).
Open Economy

 An open economy is an economy in which trade occurs between


local and domestic factors and economies in other nations (goods
and services). Trade can involve the interchange of managerial
practices, the transfer of technological know-how, and the
purchase and sale of various commodities and services.
 That is an open economy is one that trades with the rest of the
world. Example Ghana trades with Nigeria, Togo and USA
among others.
 A nation is considered to have an open economy if its citizens are
willing to trade with other nations completely unrestrictedly. To
put it another way, the nation participates in what is known as
“economic” exchanges with the rest of the world
The Circular Flow of Income in a Closed Economy

 It is assumed that the households own all the factors of


production. They sell these factors to the firms, earning factor
incomes. This is shown on the left hand side of the diagram. The
green line shows the factors of production going from the
households to the firms and the red line shows the money
payments by the firms to the households.
 The firms then use these factors to produce goods and services.
And who buys these goods and services? The households, of
course, using the income they earned from the sale of their
factors. This is shown on the right hand side of the diagram.
Again, the green line represents movements of the physical and
the red line shows the movement of the money.
The Circular Flow of Income in a Closed Economy

 Let's start with the simplest model. The economy is assumed to


consist of only two sectors: households and firms.
Injections And Leakages on the Circular Flow

 In this simple model, we have, so far, assumed that the system is


completely closed; no government involvement and no trade with
the rest of the world.
 We relax the first assumption and accept that households will not
always spend all of their income, and that firms will on occasion,
invest in new capital.
 This implies that leakages and injections do happen.
 We also assume that government gets involved in the economy
and also trade with the rest of the word take place.
Injections And Leakages on the Circular Flow

 Leakages are withdrawals from the circular flow. This occurs


when individuals and businesses preserve a portion of their
earnings instead of letting it move to another party.
 Saving (S), Tax payments (T) (direct tax and indirect tax), and
Imports (M) are examples of leakages that suppress the flow of
money.
 Injections are insertions of income into the circular flow. An
amount of money is injected into the flow when individuals or
businesses borrow.
 Money for Investment (I), Government expenditure (G), and
Exports (X) are examples of injections.
Injections And Leakages on the Circular Flow

 Where does the saving leakage go, and where does the investment
injection come from?
 A simple answer is, savings are deposited in the banking sector or
the capital markets, and the firms borrow from the same sort of
sources to invest.
Injections And Leakages on the Circular Flow
 Income received by households are not always all spent on
consumption. Some are saved while government also deduct
direct taxes such as personal income tax.
 Consumers do also consume imported goods and services. These
expenditures are paid abroad and do not stay within the economy.
Consumers also pay indirect tax when they purchase goods and
services such as VAT. These are leakages.
 Taxes received by government are spend in paying labour, goods
and services among others. Businesses also spend on capital
goods to expand their productivity and production. This is called
investments.
 Exports also generate income inflow since there is an inflow of
foreign exchange. These are Injections.
Injections And Leakages on the Circular Flow
Equilibrium and Disequilibrium Income

 A glance at the circular flow model reveals that while the sectors
such as individuals and firms pump money into the economy,
other agents withdraw it.
 This is the key concept of leakages and injections that balance
the circular flow of economic activities. The cyclic flow of money
will continue as long as leakages equal injections.
 For income to be unchanged, injections of extra spending into the
circular flow of income must equal leakages from the circular
flow. This is equilibrium.
 Where leakages are not equal to injections, disequilibrium occurs.
Equilibrium and Disequilibrium Income
 From a simple 2-sector model, individuals can either spend their
income today or save. That is;
 𝑌 =𝐶+𝑆
 Also, firms can produce output using revenue generated from the
consumer goods sold, or they can borrow to invest. That is;
 𝑌 =𝐶+𝐼
 At equilibrium, 𝑌 = 𝑌
 𝐶+𝑆 =𝐶+𝐼
 𝑆=𝐼
Equilibrium and Disequilibrium Income

Saving/ Saving (S)


Investment

E Investment (I)

0
Y GDP
Equilibrium and Disequilibrium Income

 Other leakages into the model will yield


 𝐿𝑒𝑎𝑘𝑎𝑔𝑒𝑠 = 𝑆 + 𝑇 + 𝑀
 Other injections into the model will yield
 𝐼𝑛𝑗𝑒𝑐𝑡𝑖𝑜𝑛𝑠 = 𝐼 + 𝐺 + 𝑋
 Equilibrium with the above models will be
 𝑆+𝑇+𝑀 =𝐼+𝐺+𝑋
 A change in any variable in leakages without a corresponding
change in injections will lead to disequilibrium.
Equilibrium and Disequilibrium Income

Leakages/ 𝑆+𝑇+𝑀
Injections

E 𝐼+𝐺+𝑋

0
Y GDP
Change in Injections 𝑰 + 𝑮 + 𝑿
 Increase in Injections
 An increase in Investment (I), Government expenditure (G), and
Exports (X) will lead to injections being greater than leakages.
 This will lead to extra spending in the economy, causing income
to rise.
 Decrease in Injections
 On the other hand, a decrease in any of the injection components
will lead to leakages to be greater than injections.
 This will cause less spending (spending will leave the circular
flow), and lead to a fall income.
Change in Injections 𝒊𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝑮
Leakages/ 𝑆+𝑇+𝑀
Injections
𝐸1
𝐼 + 𝐺1 + 𝑋

E 𝐼+𝐺+𝑋

0
Y 𝑌1 GDP
END OF LESSON

THANK YOU.

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