The Circular Flow Model

The Circular Flow Model Shows the economic transactions that occur between households, firms and other sectors in the economy. Money flows- We will only focus money flows as it is simpler than trying to account for the physical flows.

The Circular Flow of Income and Spending The simplest form of circular flow $ Consumption Goods and Services Producers Households The inner ring shows the real flow of goods and services The outer ring shows the money value of the flows. Factors of production (Land, Labour, Capital Incomes $ rent wages interest profit

Introduction of the Financial Sector I (Investment) d Financial Institutions C (Payments for goods and services) a S (savings) c Producers Households Name each of the money flows Savings is a type of withdrawal. As savings is income not consumed. Saving does not have to necessarily be in the form of money for example it can be in the form of storing products. But any real saving is shown leaving the economic system. The role of the financial sector is to transfer money from those who wish to save and those who wish to invest. Investment is simply creating capital goods. What are capital goods? Who knows how financial institutions such as banks make revenue? Banks help transfer money. They create a more efficient flow in the economy that would occur without them but not as efficiently. Without banks less investment would occur and therefore economic growth would be held back. b Y (Income)

The financial Sector Households do not spend all the income they earn they also save some. Savings = Income – Consumption Households usually save their income with banks. Banks then use this money to lend to firms. Firms then use these loans for investment (purchase capital)

Interest When firms borrow from banks they pay interest in return for these loans. Banks however, also pay interest to households for saving money with them. BUT! Banks will charge a higher interest to borrowers than what they pay to savers. This is how they make an income. E.g Joe saves 100 with BNZ and earns 5% interest in return for saving. BNZ then loans some of this money out but charges 10% for loans.

Open Economy Not all goods available in NZ are produced in NZ. Overseas Sector Not all goods available in NZ are produced in NZ. Imports = Goods made overseas but sold in NZ Not all goods produced in NZ are sold here. Exports = Goods made in NZ but sold overseas Exports and Imports are real flows. They are actual goods and services being traded internationally. Imports Exports Producers

Money Flows Overseas Sector Export receipts= payments from overseas firms to NZ firms for the goods and services exported overseas. Import Payments = NZ producers payments to overseas firms for the goods and services they have imported. Remember export receipts are coming into NZ Import payments are leaving NZ Exports Import Payments Export Receipts Imports Producers

An Open Economy Overseas Sector d Financial Institutions f a g c I (Investment) d Financial Institutions X (Export receipts) f M (Import payments) C (consumption) a g S (Savings) c Who knows what the difference is between an open and a closed economy? Exports are goods or services made in the home economy but sold to people overseas. Therefore export receipts are the payments for these exports Imports are goods or services made overseas but bought by people in the domestic economy. What examples or imports can you think of? Import payments are the payments for these imports. So they are a withdrawal from the economy. Producers Households b Y (Income)

Role of the Government The government collects taxes Transfers PAYE (pay as you earn) Income tax GST (goods and services tax) 15% tax on any good or service you consume. Company Tax – Taxes paid by producers to the government Transfers Subsidies that go to producers Social Welfare- (Sickness benefit, superannuation, unemployment benefit) this flow goes straight to households. Government Spending Providing goods and services. (Schools, hospitals and the police force) Payment for goods and services

Role of the Government Overseas Sector d Financial Institutions f a g I (Investment) d Financial Institutions X (Export receipts) f M (Import payments) C (consumption) a g S (Savings) c c G (Government Spending) Transfer payments are those payments by the government that represents and injection into the circular flow Such as welfare payments the DPB, subsidies etc Both firms and households pay taxation to the government. This represents a withdrawal. Government spending is the money that the government spends in the economy. This is in the form of public goods such as health care, roading etc. The govenrment can be a producer or a provider. As a producer, sales from SOE would represent C not G. Producers Households Government T (taxes) tr (transfers) b a b Y (Income)

The Circular Flow Model Overseas Sector d Financial Institutions I (Investment) X (Export receipts) e M (Import payments) C (consumption) a f S (Savings) c G (Government Spending) i Producer Households Government T (taxes) tr (transfers) g h b Y (Income)

The Circular Flow model Y= Incomes including rent wages interest and profit C= Consumption spending- the payment for goods and services S= Savings – income not spent on consumption this is a withdrawal from the economy I= Investment spending-purchase of capital goods. This is an injection into the economy X= Export receipts- Money received for exports sold M= Import payments- Payments made for imports purchased G= Government Spending- on collective goods T= Taxes the government collects from households and firms. These are used to fund G and Tr. Tr= Transfer money from one group to another, because of this transfer payments are not true expenditure.

Withdrawals and Injections Withdrawal = A money flow that leaves the circular flow I= Investment spending-purchase of capital goods. This is an injection into the economy X= Export receipts- Money received for exports sold G= Government Spending- on collective goods Injection= Flows of money into the circular flow model S= Savings – income not spent on consumption this is a withdrawal from the economy M= Import payments- Payments made for imports purchased T= Taxes the government collects from households and firms. These are used to fund G and Tr.

Money and Real Flows - Notes Money Flow – are the payments made for goods purchased or the services being provided. E.g the payment of wages in return for the use of labour Real Flow – are the movements of actual goods and services between different sectors of the economy E.g. the use of labour by a producer