THE CIRCULAR FLOW OF
ECONOMIC ACTIVITY
BASIC ECONOMIC ACTIVITIES
§ Production
§ The use of economic resources in the creation of goods and
services for the satisfaction of human wants.
§ Consumption
§ The using up of goods and services by consumer purchasing
or in the production of other goods.
§ Employment
§ The use of economic resources in production; engagement in
activity
§ Income Generation
§ The production of maximum amount an individual can spend
during a period without being any worse off.
TWO ECONOMIC UNITS
§ Household
§ The basic consuming
unit.
§ Firm
§ The basic producing
unit.
STOCK AND FLOW VARIABLES
§ Flow
§ A quantity measured over a particular period of time.
§ Stock
§ A quantity measured as of a given point in time.
The concepts of stock and flow measurements
are essential in understanding the economic
variables of wealth and income.
§ Wealth
§ Anything of valued owned. It is a stock since it is what is
owned at a particular time.
§ Income
§ The rate at which we earn money. It is a flow since income that
is saved, increases the stock of wealth.
ECONOMIC MODEL OF PRODUCTION
The Circular Flow of the Production Process
ECONOMIC
RESOURCES
HOUSEHOLDS
PRODUCING UNITS
GOODS AND
SERVICES
CIRCULAR FLOW OF GOODS AMONG PRODUCTION UNITS
RAW
MATERIALS
INTERMEDIATE GOOD
FIRM
RAW MATERIAL FIRM
CONSUMERS
INTERMEDIATE
GOODS
FINAL GOODS
FINAL GOOD FIRM
INTERRELATION BETWEEN
PRODUCTION UNITS & HOUSEHOLDS
RESOURCES
HOUSEHOLDS
RAW MATERIAL FIRM
RESOURCES
INTERMEDIATE
GOOD FIRM
RESOURCES
FINAL GOOD FIRM
ECONOMIC MODEL OF INCOME AND CONSUMPTION
The Circular Flow of Goods and Income
Among Producers & Households
RESOURCES
RAW MATERIAL
FIRM
MONEY PAYMENT FOR RERESOURCES
RESOURCES
MONEY PAYMENT FOR RESOURCES
HOUSEHOLDS
INTERMEDIATE
GOOD FIRM
RESOURCES
MONEY PAYMENT FOR RESOURCES
MONEY PAYMENT FOR PURCHASE OF FINAL
GOODS
FINAL GOODS
FINAL GOOD FIRM
THE CIRCULAR FLOW OF INCOME
INCOME FLOW OF WAGES,
INTERESTS, RENTS
HOUSEHOLDS
PRODUCING UNITS
PURCHASES OF GOODS AND
SERVICES
CIRCULAR FLOW OF INCOME AMONG PRODUCTION UNITS
MONEY PAYMENTS FOR
RAW MATERIALS
RAW MATERIALS
FIRM
INTERMEDIATE
GOOD FIRM
MONEY PAYMENTS FOR
INTERMEDIATE GOODS
FINAL GOOD
FIRM
MONEY PAYMENTS FOR
FINAL GOODS
HOUSEHOLDS
THE CIRCULAR FLOW OF OUTPUT AND INCOME
Circular Flow of Physical Goods and Money Income
Goods and Services
Factors of Production
(land, labor, capital, entrepreneur)
Household
Sector
Business
Sector
Payments of Factors
(rent, wages, interest, profit)
Payment of Purchase
of goods and services.
THE CIRCULAR FLOW OF
GOODS & INCOME OF HOUSEHOLDS & FIRMS
WITH THE GOVERNMENT & FOREIGN COUNTRIES
GOVERNMENT
Wages, Transfer Payments
Taxes
Purchase of Goods
& Services
Taxes
Economic Resources
Purchase of Goods & Services
HOUSEHOLDS
PRODUCING UNITS
Income Payments of Wages, Rent,
Dividends, & Interests
Goods & Services
Money Payments for
Imports
Money Payments for
Exports
FOREIGN COUNTRIES
IMPLICATIONS OF THE
CIRCULAR FLOW OF ECONOMIC ACTIVITY
1.
The goods, resources, and money payments
will flow as long as households continue to
consume, and as long as firms continue to
produce.
2.
That since goods and resources flow in
exchange for payments, the rate of
payments flow will in the end be the same.
Money is the inducing factor, and the pillar
of the price system. Without it, there is no
price system.
INFLOWS AND OUTFLOWS
§ Outflows Withdrawals (factors that decrease the level of
economic activity)
§ Savings
§ Taxes
§ Imports
§ Inflows Injections (factors that increase the level of economic
activity)
§ Investment
§ Government Spending
§ Exports
THE CIRCULAR FLOW OF ECONOMIC ACTIVITY REFLECTING
THE OUTFLOWS & THE INFLOWS
Economic Resources
HOUSEHOLDS
Purchase of Goods & Services
PRODUCING UNITS
Income Payments of Wages, Rent,
Dividends, & Interests
Goods & Services
IMPORTS
Foreign Countries
EXPORTS
TAXES
Government
EXPENDITURES
SAVINGS
Banks
INVESTMENTS
Outflows are difficult to control because they are dependent on
income. When income increases, we expect savings, taxes, and
imports to increase.
Inflows are easier to manipulate. The proper use of policy
enables the government to encourage exports and investments and
to increase its expenditures when it desires to expand the flow of
economic activity.
THREE SETS OF POLICY
§ Monetary policy
§ Affects the savings and investment.
§ Fiscal policy
§ Controls taxes and government expenditures.
§ Trade policy
§ Affects a country’s exports and imports.