The Circular Flow Model

Objectives:

By the end of this section you will be able to:-

Construct a circular flow diagram(s) in real and money terms (this may involve the construction of a circular flow diagram
Show and explain the interdependence of households, producers, government, the financial sector and the overseas sector
Understand the markets inherent in the model, including the finished goods and services market, the resource markets, the domestic money market and the foreign exchange market.

The circular flow model shows how the FIVE different sectors of the economy are linked. We will be looking at both money flows and real flows.
Real Flows look at the flow of physical things through the economy. In the Circular Flow Model they are
- Labour (the flow of resources.
- Commodities
- Exports
- Imports
Money Flows look at the flow of money through the economy. Some of the money flows are linked to real flows. In the Circular Flow Model they are
- Income (linked with labour)
- Consumer spending or consumption spending (linked with commodities).
- Savings
- Investment or Venture Finance.
- Government Spending
- Taxes
- Transfer Payments
- Subsidies
- Export Receipts (linked with Exports)
- Import Payments (linked with Imports).

Households and producers

Households and producers rely on each other. Households rely on Producers for Income and Commodities and Producers rely on Households for Labour and Consumption Spending. There is a mutual dependence - they are interdependent. Households rely on producers for Income and Commodities and produicers rely on households for Labour and Consumer Spending.

SIMPLE CIRCULAR FLOW MODEL SHOWING BOTH REAL AND MONEY FLOWS

THE RESOURCE MARKET

This the market that corresponds with the real flow of labour.

Households are the owners of the resources

How are households and producers / firms interdependent?

Income includes wages, salaries etc.
If Income increases then consumers will spend more meaning that profits for firms will increase leading to more employment and greater spending in the economy. The opposite will happen if income is reduced.

Financial sector

Most people do not spend all their income. Some is saved for future buying. Savings can be deposited in banks or other firms in the financial sector and earn interest. As income increases people tend to save more.

The Financial Sector use these savings to make loans to producers wanting to expand e.g. more buildings, machinery or for a farmer more land, stock, and fertilizer etc.
This is called investment. Investment in Economics is the buying of capital goods, this means the buying of machinery or buildings or anything that is used in the production process and is man made.
The Financial Sector acts as an intermediary between households (with savings to be invested) and producers (who need money to invest).

Investment from the financial sector to producers can also be in the form of Venture Finance. Producers are borrowing to invest in new businesses or or expansion.

The Financial Sector makes a profit from the difference between the interest rate they pay savers (e.g. 5 percent) and the interest rate they charge producers (e.g. 7 percent).

The financial sector acts as an intermediary between households who want to save money and firms who want to borrow money for investment.

SIMPLE CIRCULAR FLOW MODEL INCLUDING THE FINANCIAL SECTOR

What would happen if the financial sector were removed from the Circular Flow?

Overseas sector

NZ exports a number of goods and services overseas, these include dairy products, beef, lamb, tourism, etc. The exports are part of the real flow. Export Receipts is the money flow that corresponds with the real flow.

NZ imports a number of items, these include cars, petrol, fruit etc. The imports are part of the Real Flow and the money flow that corresponds with the real flow is Import Payments.

Money flows into NZ producers for exports (export receipts) and out of NZ to overseas suppliers as payment for our Imports.

The balance of payments is a measure of how much money is leaving NZ compared to how much money is entering NZ. It shows Export Receipts minus Import Payments. The Balance of Payments records if there is a surplus i.e. Export receipts exceed Import payments; or a deficit i.e. Import payments exceed export receipts. If a deficit results then NZ must borrow the difference overseas.

A closed economy does not trade at all with the outside world. How would NZ suffer if NZ was a closed economy?

Source: Statistics New Zealand, September 2005.

The graph above shows imports versus exports in New Zealand
In which time periods did export receipts exceed import payments?

What is the trend shown in the above graph?

Government sector

Government spending is large on services like education, health, roads, police, defence etc.

This must be added to consumer spending to give total spending on goods and services. Government spending comes from money collected as taxes.

Income tax is paid by all wage and salary earners. It is mostly paid using P.A.Y.E. (Pay As You Earn) and is automatically deducted from wages. Income after tax is called disposable income.

Company tax must be paid on all profits by firms, including banks (the financial sector). These are direct taxes.

Indirect taxes like GST also provide money. GST (12.5% of the price) is paid by producers on all goods and services sold. This increases firm costs, although part of the extra cost is passed on to consumers in a higher price. Indirectb taxes also include excise taxes. These are taxes on alcohol, tabacco etc. and are used to try and discourage their consumption.

Subsidies These are paid to producers to help them to produce a certain type of good or service the Government believes should be produced more. Subsidies enable firms to produce more, charge a lower price, and thereby sell more. In NZ things like the Royal New Zealand Ballet are subsidised by the Government.
Transfer Payments These are paid to Households in the form of money transfers like benefits. These are paid to help people who may be sick or in between work.

What is government spending and to which money flow is it added to?

How does government get this money?

Example:

A lot of T.V. programmes made in NZ for NZ television are subsidised by the Government. This is to help encourage NZ producers to make NZ programmes in order to let New Zealanders be able to watch NZ television on T.V.

Why are government subsidies paid?

Interdependence

All the sectors depend on each other and none could operate fully without the other sectors e.g. government is needed to provide services not provided by producers and to assist the needy.
The money for government comes from households, producers and banks.

All the sectors are interdependent - they are mutually reliant, they all rely on each other.

For example.

The household sector and the producer sector are interdependent. Households rely on producers for income and commodities. Producers rely on households for labour (resources) and consumer spending. They rely on each other,; they are interdependent.

Explain how the government and households are interdependent

Gross Domestic Product - GDP

This is the value of all goods and services produced in an economy in a given year and consists of the money flows within the economy.

GDP = Income in the economy. AND

GDP = Consumption + Investment + Government Spending + (Exports - Imports)

When the economy is growing rapidly and GDP is increasing this is called a boom.

When the economy is growing slowly and GDP is growing at a very slow rate or not at all it is called a recession.

When the economy is getting smaller (negative growth) it is called a depression.

The Impact Of Changes On The Circular Flow

INJECTION OF MONEY INTO THE CIRCULAR FLOW.

If money is put into the Circular Flow then this will flow onto other areas of the economy.

Injections of money include.

Export receipts. (X)
Investment. (I)
Government Spending. (G)

Any increase in any of these factors will lead to an increase in production, more employment, greater incomes and increased consumer spending. The economy will experience a boom.

e.g. An increase in export receipts.

WITHDRAWAL OF MONEY FROM THE CIRCULAR FLOW.

If money is taken out of the Circular Flow then this will flow onto other areas of the economy.

Withdrawals of money include.

Import payments. (M)
Savings. (S)
Government Taxation. (T)

Any increase in any of these factors will lead to an decrease in production, less employment, smaller incomes and decreased consumer spending. The economy may experience a recession.

An increase in imports will have the opposite effect of the one shown above.

An appeciation of the New Zealand dollar will cause an increase in imports and a fall in exports.