The Circular Flow of Income and Expenditure The circular flow diagram shows the transactions among households, firms, governments, and the rest of the world.

The Circular Flow of Income and Expenditure Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households.

The Circular Flow of Income and Expenditure Households buy consumer goods and services. The red flow, C, shows consumption expenditures.

The Circular Flow of Income and Expenditure Households save, S, and pay taxes, T. Firms borrow some of what households save to finance their investment.

The Circular Flow of Income and Expenditure Firms buy capital goods from other firms. The red flow I represents this investment expenditure by firms.

The Circular Flow of Income and Expenditure The Government buys goods and services, G, and borrows or repays debt if spending exceeds or is less than taxes

The Circular Flow of Income and Expenditure The rest of the world buys goods and services from us, X and sells us goods and services, M—net exports are X - M

The Circular Flow of Income and Expenditure And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative.

The Circular Flow of Income and Expenditure The blue and red flows are the circular flow of income and expenditure. The green flows are borrowing, lending, and taxes.

The Circular Flow of Income and Expenditure The sum of the red flows equals the blue flow. That is: Y = C + I + G + X - M

Expenditures Expenditures are purchases of goods and services. Consumption expenditure (C) Investment expenditure (I) Government spending (on goods and services) (G) Net Exports (X-M) Exports (X) Imports (M)

Expenditures equal Income Expenditures= C + I + G + X – M All expenditures become someone’s income so Y (income) = C + I + G + X – M

Government Government spending: Goods and services (G) Roads, health care, education, helicopters, police officers salaries, judges salaries. Government revenue: Taxes (Income from Crown corporations) (Tariffs) Less Transfers to persons (part of net taxes) GST rebates, unemployment insurance, pensions, subsidies Interest on the debt (substantial) NOTE: The gov’t is not buying services, so transfers are not an expenditure.

Budgetary Deficits and Surpluses Spending Goods and services (G) + Transfers to persons (Tr) Revenue Taxes (Tx) Net Taxes Tx – Tr = NT Surplus G + Tr < Tx G < Tx – Tr G < NT Deficit G + Tr > Tx G > Tx – Tr G > NT

Savings and Investment Investment is financed by savings Savings have three sources: Savings by households The part of income households do not spend on consumption or net taxes. (S = Y - C - NT) Savings by governments NT – G = savings Savings of foreigners M – X = foreign borrowing

STOCKS AND FLOWS FLOWS STOCKS Income : the goods and services produced each year Deficits: The excess of spending over income each year Investment: Goods produced to be used in production each year Surpluses: The excess of revenue over expenditures each year. STOCKS Wealth: All the goods a person owns. Wealth is the sum of past net saving. Debt: the sum of all past deficits less all past surpluses Capital: All the investment goods owned. Capital is the sum of past net investment