2 Financial Institutions Circular Flow ModelLabourOverseas SectorGoods and ServicesImport PaymentsExport ReceiptsIndirect TaxDirect TaxHouseholdsGovernmentProducersWelfare PaymentsSubsidiesConsumer SpendingInterest on SavingsInterest on LoansIncomeInvestment LoansFinancial InstitutionsSavingsThe circular flow model is an economic model that illustrates the interdependence that exists between the different sectors operating in an economy.
3 AssumptionsThe basic circular flow of income consists of six assumption: the economy consists of two sectors which are households and firms, households spend all their income on goods and services or consumption which means that there is no savings, all output produced by firms is purchased by the households, there is no government sector, there is no overseas sector and there is no financial sector.
4 LimitationsThe model does not indicate the size, health or speed of growth of an economy. It only shows how the different parts of the economy are related to each other. For example, the types of goods being produced cannot be distinguished in the model, so a local authority drive to clean up graffiti will increase GDP, but it will not add any new goods and services to the economy.The market only counts market transactions. Therefore not all economic activity is accounted for in the model. Such things as the black market, DIY activities and unpaid work are not counted.
5 Two Sector Model Households Firms IncomeLabourHouseholdsFirmsGoods and ServicesConsumer SpendingIn this two sector model there are only households and firms. Households provide firms with labour, in return households receive income. Firms provide goods and services to households and in return firms receive consumer spending. This shows two money flows and two real flows.
6 Financial Institutions Three Sector ModelIncomeLabourHouseholdsFirmsGoods and ServicesInvestment LoansInterest on SavingsConsumer SpendingInterest on LoansSavingsFinancial InstitutionsIn this three sector model, a financial sector is added to a two sector model. There are four more money flows added to the circular flow model. Households save money in a financial institution and financial institution uses this money to lend to firms. Firm provide the financial institution with interest on the loans and the financial institutions provide households with interest on their savings.
7 Financial Institutions Four Sector ModelIncomeLabourIndirect taxDirect TaxHouseholdsGovernmentFirmsWelfare PaymentSubsidiesGoods and ServicesInvestment LoansInterest on SavingsConsumer SpendingInterest on LoansSavingsFinancial InstitutionsA four sector model has a government sector added to a three sector model which includes households, firms and financial institutions. A four sector model now has four more money flows added to the circular flow model of three sectors. The government collects direct tax from households and indirect tax from firms. The government provides households with welfare payments and provides firms with subsidies.
8 Financial Institutions Five Sector ModelOverseas SectorExport receiptsIncomeLabourImport paymentsIndirect taxDirect TaxHouseholdsGovernmentFirmsWelfare PaymentSubsidiesGoods and ServicesInvestment LoansInterest on SavingsConsumer SpendingInterest on LoansSavingsFinancial InstitutionsA five sector model has an overseas sector added to a four sector model. There are two more real and two more money flows added to the four sector model. Firms exports to the overseas sector and in return they receive export receipts. Firms import from the overseas sector and they provide the overseas sector with import payments.
9 Injections Withdrawals Injections increase the amount of economic activity, which is the amount of buying and selling that occursE.g. Consumer spending, investment, government spending and export receipts.Withdrawals will decrease the amount of economic activity as there is less money circulation within our economyE.g. Savings, taxes, import payments.
10 Injections are important for economic growth Injections are money entering the circular flow model which increases economic activity.Economic growth is an increase in the total output.Injections are important for growth because as there is more money inflow into the circular flow model, firms income increases, this causes households income to increase which leads to consumer spending also increasing. Firms will now increase productivity and production, which is an increase in actual output and therefore growth increases. Injections are important for economic growth.
11 Using the Circular Flow Model Part Two BUsing the Circular Flow Model
12 How an increase in household savings causes growth. Savings increase, which means that the financial sector can now receive more savings form households, firms investment can increase as financial sectors now have more money to lend to firms, firms buy more capital goods to increase productivity and production as there are more machines and more goods are produced with the same number of workers and therefore production increases so growth occurs as the total output increases.
13 How an increase in firms investment causes growth. Investment increases, as firms profits increase, more resources are purchased as firms have the money to be able to invest in capital goods to produce more goods and services. Consumers income increases as they work longer and this leads to an increase of the amount of goods and services produced, which means productivity has increased.Overall output is increased so growth increases.
14 How an increase in resource use causes growth. As output increases amount of resources required increases as more resources are needed to produce more goods and services, consumers incomes increase as they have to work longer hours to produce the resources, consumer spending increases as they now have more disposable income. More goods and services are produced to satisfy consumer wants.So growth increases because overall output has increased.
15 How an increase in consumption causes growth Consumption spending increases meaning that consumer spending as more goods and services are being purchased. Firms are more confident as their goods and services are being sold and therefore the firms increase their output which will lead to an increase in revenue and firms profit. Firms increase their investment to produce more goods and services, workers income increases as they work for longer hours and there is more disposable income for households which increases savings.So growth occurs as there is now an increase in productive capacity in the economy
16 How an increase in exports causes growth. Exports increase as firms produce excess goods and services which they sell to overseas buyers as they receive more money when these goods and services are sold overseas. Export receipts are increases as more goods and services are sold overseas and firms profits are increased because they receive more money by exporting. Investment increases as firms want to produce more and therefore output increases as more goods and services are produced. Consumers incomes increase as they work for longer hours to producer the greater amount of output and so growth occurs as there is an increase in productive capacity now.
17 How an international event being held in NZ causes growth. An international event being held in NZ means that there is an increase in tourists in NZ, who will use NZ’s services, so spending in regions increase as there are tourists in the regions. Firms confidence increases so investments increases because firms will want to produce greater goods and services as there will be more consumers demanding goods and services because of the international event being held in NZ. In order to create more goods and services, firms will have to higher more staff which leads to an increase in employment and therefore consumer income increases as workers work for longer hours. As consumers now have more disposable income their consumer spending increases and so growth occurs because the economy is growing.