1. Economic Issues: An introduction
Outcome Two: The Circular Flow of National Income

2. Lesson Structure 1. Introduction 2. The ‘two sector’ model
3. A more realistic model:
Injections
Withdrawals
4. Changes in injections and withdrawals

3. 5. Circular flow and Keynesian Demand Economic Policies: Problems

4. 2. The Two Sector Model How an economy operates via a simplistic model
The process of production and consumption
Two basic sectors:
Firms: wealth producing sector
Households: consuming sector
Represents how wealth is created in an economy

5. The ‘Two Sector’ Model Flow of resource inputs and outputs
Incomes (Wages, interest, rent, profits)
Factors of production (land, labour, capital and enterprise)
Firms
Households
Output of goods and services
Consumer spending
Flow of resource inputs and outputs
Flow of income and expenditure

6. There are two kinds’ relationships between firms and households:
a. Monetary relationship
b. Physical relationship

7. National Income = National Expenditure = National Output
A circular flow of income is created
National Income = National Expenditure = National Output
(Assuming that an economy consists of only two sectors: ‘firms’ and ‘households’).

8. 3. Injections and Withdrawals
The two sector model in its present form would be realistic if:
Firms paid out all the income they receive to domestic households
Households used all of their income to consume the output produced by domestic firms
Money would continue to flow directly between firms and households

9. In reality…
Some income will leave the circular flow
Some income will enter the circular flow
Account for the government and foreign sector

10. Enter Injections and Withdrawals
The level of national income is influenced by:
Withdrawals (‘leakages’) from the circular flow of income (income entering the flow)
Injections into the circular flow of income (income leaving the flow)

11. Injections (J) into the Circular Flow
Injections into the flow will result in an increase in the level of national income
Three types of injections:
a. Government spending (G)
b. Investment (I)
c. Exports (X)

12. Total Injections = G + I + X
Injections (J) into the Circular Flow
Injections = an increase in national income
Income
Government Spending (G)
Households
Firms
Investment (I)
Exports (X)
Consumption
Total Injections = G + I + X

13. Withdrawals (W) from the Circular Flow
Withdrawals from the flow will result in a decrease in the level of national income
There are three types of withdrawals:
a. Savings (S)
b. Taxation (T)
c. Imports (M)

14. Withdrawals (W) from the Circular Flow
Income
Taxation (T)
Withdrawals represent a leakage = a decrease in national income
Households
Savings (S)
Firms
Imports (M)
Consumption
Withdrawals: S+T+M

15. The Circular Flow of Income
Injections (J)
Withdrawals (W)
Firms
Income
Consumption
Investment (I)
Savings (S)
Government Spending (G)
Exports (X)
Taxation (T)
Imports (M)
Households

16. 4. Changes in Injections and Withdrawals
How do changes in injections and withdrawals affect the level of national income in an economy?
Lets examine what happens when…
a. Injections are greater than withdrawals
b. Injections are less than withdrawals
c. Injections and withdrawals are equal

17. Changes in Injections and Withdrawals
a. If injections are more than withdrawals:
National income will rise
More income entering than leaving the economy
b. If injections are less than withdrawals:
National income will fall
More income leaving than entering the economy
And Finally…

18. Equilibrium in the Circular Flow
c. If injections are equal to withdrawals:
National income remains stable
The economy will be in a state of equilibrium
Amount of income entering equals the amount of income leaving the economy

19. Class Exercise: What Happens to National Income If…
1. Individuals decide to save more of their money?
National income will fall as savings represents a withdrawal of
income from the circular flow. Individuals would have less income
to spend on goods and services
2. The Government increases spending in the economy e.g. builds 10 new hospitals?
National income will rise as Government expenditure represents an
injection of income into the circular flow. This would increase the level of
employment in the economy, in turn increasing the amount of consumer
spending and income generated.

20. Class Exercise: What Happens to National Income If…
3. Demand for UK exports increases?
National income will rise as export spending represents
an injection of income into the circular flow.
4. Level of investment in the UK increases?
National income will rise as increased investment
represents an injection of income into the circular flow

21. 5. The Government increases the amount of tax paid on goods and services (VAT)?
National income will fall as taxation represents a withdrawal of income
from the circular flow. Individuals would have less income to spend on
goods and services
6. The demand for imports in the UK increases?
National income will fall as import spending represents a withdrawal of
income from the circular flow. Individuals would have less income to
spend on goods and services. This income will enter the circular flow of
income in another Country.

22. Circular Flow/Keynesian Economic Policy: Problems
The level of national income in the economy will influence the level of unemployment-why?
We have to consider aggregate demand (total demand for all goods and services produced in the economy)
If AD in the economy falls, national income decreases
If less goods and services are produced, this will lead to higher unemployment

23. Unemployment caused by a decrease in aggregate demand = demand deficient unemployment
This type of unemployment is associated with John Maynard Keynes

24. Circular Flow/Keynesian Economic Policy: Problems
If unemployment is caused by a lack of AD, the government should intervene in the economy to increase AD by using fiscal policy.
Fiscal policy can be used to increase AD and employment by increasing government spending and/or decrease taxation
Example
Increasing government expenditure to create more employment and to stimulate an increase in demand for goods and services (multiplier effect).
However, increasing AD to lower unemployment has various problems:

25. Problem One: Inflation
If unemployment is caused by a lack of AD, the government should intervene in the economy to manage AD e.g. increasing government expenditure to create more employment and stimulate an increase in demand for goods and services (multiplier effect)
However, as the economy nears full employment it becomes more difficult for producers to increase their output.
If demand continues to rise and producers become unable to respond to these shortages, then prices will be forced upwards
Inflation is one of the criticisms associated with increasing government spending to increase national output and employment

26. Problem Two: Budget Deficit/Crowding Out
If the government increases expenditure to lower unemployment, this could lead to a budget deficit
Budget deficit: government expenditure greater than revenue from taxation
This increases the level of government debt in the economy
The government will have to borrow money to eliminate this deficit

27. Problem Two: Budget Deficit/Crowding Out
Increases in public borrowing can result in interest rates increasing, making the cost of borrowing more expensive for the private sector businesses. This situation can be referred to as ‘crowding-out’ the private sector.
An increase in government debt and crowding out of the private sector are two additional consequences associated with increasing government spending to increase national output and employment

28. Problem Three: Time Lags
The use of government expenditure to lower unemployment and raise national output can be subject to time lags. E.g. increase government expenditure to lower unemployment: the policy may only come into effect when the economy has already recovered and experiencing a boom
Time lags is another consequence associated with increasing government spending to increase employment and national output

29. Problem Four: Dependence on Government Intervention
Increasing government expenditure to increase levels of national output and employment was one of the main policies applied by successive governments in the 1950s and 1960s
Unemployment reached historically low levels but increased government intervention through increased government expenditure was criticised by the 1970s as this policy proved to be unworkable in solving the economic difficulties experienced, particularly the economic problem of stagflation (high unemployment and high inflation)
This is an additional consequence associated with increasing government spending to increase national output and employment

30. Output=Income=Expenditure
Summary
Circular Flow is a model of the economy
Relationship between firms and households
Output=Income=Expenditure
For our model to be realistic, we have to consider:
Injections into the flow
Withdrawals from the flow

31. Three types of Injections:
Government spending
Exports
Investment
Three types of Withdrawals:
Taxation
Imports
Savings

32. a. If injections are more than withdrawals:
National income will rise
b. If injections are less than withdrawals:
National income will fall
c. If injections are equal to withdrawals:
National income remains stable
The economy will be in a state of equilibrium