1. Circular Flow in Economics
Government
Circular Flow in Economics

2. The Circular-Flow Diagram
Circular Flow in Economics: How households and businesses interact in the market for resources and in the market for goods and services, and see how money keeps the whole process moving.
The circular flow model highlights the “flows” within the economy―the flow of economic resources, goods and services, and the flow of money.

3. The Circular-Flow Diagram…
… is a simple depiction of the macroeconomy.
… illustrates GDP as spending, revenue, factor payments, and income.
First, some preliminaries:
Factors of production are inputs like labor, land, capital, and natural resources.
Factor payments are payments to the factors of production. (e.g., wages, rent)
If your students already know the terms “factors of production” and “factor payments,” you may wish to delete the “preliminaries” from this slide.

4. The Circular-Flow Diagram
Households:
own the factors of production, sell/rent them to firms for income
buy and consume Goods & Services (g&s)
Firms
Households
This and the following two slides build the Circular-Flow Diagram, piece by piece.

5. The Circular-Flow Diagram
Firms
Households
Firms:
buy/hire factors of production, use them to produce g&s
sell Goods & Services (g&s)

6. The Circular-Flow Diagram
Revenue
Markets for Goods & Services
Spending
G & S sold
G & S bought
Firms
Households
Wages, rent, profit
Factors of production
Income
Labor, land, capital
In this diagram, the green arrows represent flows of income/payments. The red arrows represent flows of goods & services (including services of the factors of production in the lower half of the diagram).
To keep the graph simple, we have omitted the government, financial system, and foreign sector, as discussed on the next slide.
Changing the animation on this slide:
If you wish, you can easily change the order in which the markets and arrows appear. From the “Slide Show” drop-down menu, choose “Custom Animation…” Then, a box will appear (maybe along the right-hand-side of your PowerPoint window) that allows you to modify the order in which things appear (as well as other aspects of the animation). For further information, open PowerPoint help and search on “change the sequence of animations.”
Markets for Factors of Production

7. What This Diagram Omits…
The government
collects taxes
purchases g&s
The financial system
matches savers’ supply of funds with borrowers’ demand for loans
The foreign sector
trades g&s, financial assets, and currencies with the country’s residents
In future chapters, we will study the role of each of these in greater detail.
We could draw a more complicated circular flow diagram that includes the government, financial system, and foreign sector. Including them, however, would not change the basic conclusion that GDP simultaneously measures the country’s total income, expenditure, revenue, and factor payments.

8. Expanded Circular Flow
Government purchases of goods and services is paid for by tax receipts as well as by government borrowing.
Households earn income via the factor markets from wages, interest on bonds, dividends on stocks, and rent on land.
Wages, rents, interest, profits
Firms (production)
Household
Factor services
Goods
Government Spending
Other countries
Financial markets
Government
Taxes
Savings
Investment
Personal consumption
Exports
Imports
Via the financial markets, private savings is channeled to firms for investment spending.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

9. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
The expanded circular flow diagram shows the transactions among households, firms, governments, and the rest of the world.

10. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
These transactions take place in factor markets, goods markets, and financial markets.

11. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households.

12. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Households buy consumer goods and services. The red flow, C, shows consumption expenditures.

13. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Households save, S, and pay taxes, T. Firms borrow some of what households save to finance their investment.

14. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Firms buy capital goods from other firms. The red flow I represents this investment expenditure by firms.

15. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than taxes.

16. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
The rest of the world buys goods and services from us, X, and sells us goods and services, M—net exports are X - M
Foreigners can also buy stocks and bonds in the U.S. financial markets.
Exports (X) generate an inflow of funds into the country from the rest of the world
Imports (M) lead to an outflow of funds to the rest of the world.

17. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative.

18. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
The blue and red flows are the circular flow of expenditure and income. The green flows are borrowing and lending.

19. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
The sum of the red flows equals the blue flow.

20. Expanded Circular-Flow Diagram: The Flows of Money Through the Economy
That is: Y = C + I + G + X - M

21. An Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

22. SUMMARY: The Circular Flow… Matching Buyers and Sellers
Income
Market for Factors
Factor Payments
…who in turn pay for them with wages, rent, interest, and profits.
Households “sell” resources to businesses…
Labor, Land, and Capital for Sale
Labor, Land, and Capital Purchased
Households
Businesses provide final goods and services to households…
Firms
Goods and Services Purchased
Goods and Services for Sale
Consumption
Market for Goods and Services
Firm Revenue
…who in turn pay for them with money.

23. SUMMARY: The Circular Flow… Matching Borrowers and Lenders
Income
Market for Factors
Factor Payments
Businesses can borrow from the bank to obtain capital to purchase inventory
Private Savings
Interest
Financial Markets
Loans
Interest
Public Savings
Households
Firms
Transfers
Transfers
Government
Individuals and governments earn a rate of return from their savings
Taxes
Taxes
Government Spending
Consumption
Market for Goods and Services
Firm Revenue

24. Circular Flow
Expanded Circular Flow