Circular Flow of Income: Output, Income, Expenditure

• The circular flow of income is a way to show how money moves around in an economy between different groups of people or businesses; kind of like a giant loop.
• The simplest model of circular flow of income includes output, income, and expenditure.

Output

• Businesses produce goods and services.

Income

• Businesses pay wages to workers (households) for their labor.

Expenditure

• Households use their income to buy goods and services from businesses.
• A bakery makes bread (output), and when it sells bread, it earns money (income).
• The income from bread sales is used by businesses to pay wages to their workers (households).

Open Economy

• Is involved in trade with other economies, such as a bigger village that trades with the outside world.
• In an open economy, people can buy and sell goods from other countries.

Closed Economy

• Is not involved in trade with other economies, like a small village that does everything by itself.
• In a closed economy, there is no buying or selling with other countries.

Leakages

• Leakages refer to money leaving the circular flow.
• Savings: From households to banks/financial institutions to save a portion of their wages, interest, profits, or rent.
• Savings arrows leave payment factors instead of households' to simplify the diagram.

Direct Taxes

• Taxes imposed directly on income or wealth, such as income tax or corporate tax.
• Direct taxes are deducted from wages, interest, profit, and rent (factor payments) before households receive their income.
• Factor payments represent the total income earned by households, so direct taxes are shown as leaking from factor payments before households decide how much to save or spend.

Indirect Taxes

• Taxes imposed on goods and services, such as VAT (value-added tax) or sales tax.

Why indirect taxes leak from consumer spending

• Indirect taxes (e.g., sales tax or VAT) are paid when households buy goods and services.
• Taxes are included in the price of products, which reduces the actual purchasing power of households.
• The leakage appears from consumer spending, showing that part of what households spend goes to the government instead of firms.

Imports

• Imports represent spending that goes outside the domestic economy.

Why the imports arrow leaves from consumer spending:

• Imports represent goods and services purchased from foreign firms.
• When households spend money on imported goods and services, that money leaves the domestic economy and goes to foreign producers.
• Instead of circulating within the economy, part of household spending flows out to other countries.

Injections

• Injections refer to money earned from selling goods and services to foreign buyers.
• When foreign consumers buy domestic goods and services, money flows into the domestic economy from abroad.
• This increases firms' revenue, allowing them to pay more wages, rent, interest, and profit to households.
• The export arrow flows into factor payments because money earned from exports eventually becomes income for households through wages, rent, interest, and profit.

Government Spending

• Money spent by the government on public goods and services and infrastructure.
• The government spends money on public services and infrastructure such as roads, hospitals, and schools.
• Money flows into firms, increasing their income and boosting economic activity.
• Government buying of goods and services from firms increases revenue, and governments also hire firms for public projects.
• As government spending increases firms' revenue, they can then pay more wages, rent, interest, and profit, which flows into factor payments for households.

Investment

• Money spent by firms to expand, buy capital, or improve production.
• Firms borrow money from banks (which comes from household savings) to invest in capital, expand production, or innovate.
• Firms invest to expand production.

Why investment arrow flows into consumer spending on goods and services

• Investment creates jobs and income (firms often hire more workers and pay higher wages when they invest).
• This means more income to spend on goods and services.

Equilibrium

• For income to be unchanged, injections = leakages; this is known as equilibrium income.
• Another way to think of equilibrium income is to imagine the economy like a bathtub.
• Water is coming in via income, investments, government spending, and exports, while water is also going out via savings, taxes, and imports.
• Amount of water going in = the amount going out (equilibrium, economy is stable).
• More water is coming in than going out; the water level rises (economy grows, GDP↑).
• More water is going out than coming in; the water level drops (economy shrinks, GDP↓).
• Injections: (greater money entering the economy) = Investment (I) + government spending (G) + Exports (X).
• Leakages: (money leaving the economy) = Saving (S) + Taxes (T) + Imports (M).
• If injections are greater than leakages, there will be extra spending in the economy, causing income to rise (GDP↑).
• If leakages are greater than injections, more spending will leave the circular flow, causing income to fall (GDP↓).
• Money flow (income and spending) in a closed economy only includes households and firms.
• Firms pay factor payments (wages, interest, profit, and rent) to households in exchange for resources (labor, capital, land, and enterprise).

Firms pay factor payments

• Firms pay wages to labor for the work they do, interest on capital, and profit shares to shareholders.
• They also pay rent for the land they use (natural resources, office spaces, farms, etc.). Households receive wages by working jobs, interest from bank savings/loans/bonds, profits as business owners/shareholders, and rent from land/property.
• Once households receive factor payments, households spend that income on goods and services produced by firms.

Inner circle

• Shows the real/physical flow of goods and services.
• Households provide factors of production (land, labor, capital, services, and entrepreneurship) to firms.
• Firms use these to produce goods and services and sell them back to households for consumption.

Open Economy

• Unlike a closed economy, open economies involve interactions with the government, financial sector, and international trade.
• In practice, leakages exit the circular flow and injections enter the circular flow.

Leakages (Outflows)

• Reduce spending in an economy; withdrawals from circular flow of income.
• Savings : Money saved in banks instead of being spent.
• Taxes: Money paid to the government (direct and indirect taxes).
• Imports: Money spent on foreign goods and services, leaving the economy.

Injections (Inflows)

• Increased spending in an economy (additions to circular flow of income).
• Investment : Money invested in businesses for growth and production.
• Government spending: Public sector spending on infrastructure, healthcare, etc.
• Exports: Money earned from selling goods and services to foreign buyers.
• If injections (I+G+X) > leakages (S+T+M), the economy grows. If leakages (S+T+M) > injections (I+G+X), the economy shrinks.
• Savings: Money saved in banks instead of being spent.

Taxes

• Money paid to the government (direct and indirect taxes).

Imports

• Money spent on foreign goods and services, leaving the economy.
• Money invested in businesses for growth and production.
• If injections (I+G+X) > leakages (S+T+M) -> Economy grows.
• If leakages (S+T+M) > injections (I+G+X) -> Economy shrinks.

Two sector economy

• In a two-sector economy, equilibrium happens when total savings equal total investment.
• This is the simplest version of an economy.
• Households are the people who earn income and spend money.
• Firms (businesses) produce goods/services and pay wages.
• The two-sector economy occurs when total investment is equal to total savings.

Four Sector Economy

• This model is complete, and ignores the government and foreign trade.
• Households are people who earn and spend money, firms produce goods and services, the government collects taxes and spends money on public services.
• The foreign sector trade with other countries (imports and exports).

Equilibrium happens when: (S+T+M) = (I+G+X).

• This mode shows how taxes, trade, and government spending affect the money economy.

Savings curve

• Savings curve (upward sloping): As income (GDP) rises, people save more.

Investment line

• (horizontal): Firms invest a fixed amount, no matter the income level.
• If people save too much, businesses will not sell enough, so production (GDP) falls.
• investment is rising; therefore, leakages will be more than injections (not equilibrium).

Equilibrium income

• The equilibrium in a four-sector economy occurs where total savings and taxes plus imports are equal to the sum of investment, government spending, and exports.

Above shows

• What will happen if tax rates rise without any changes in government spending.
• More tax revenue collected from households and firms will reduce the amounts they have available for spending.
• GDP is reducing, and a rise in savings/imports will also cause GDP to fall (at least in the short run).

Aggregate Demand

• Aggregate demand is the total demand for an economy's goods and services at a given price level in a given time period.
• Aggregate demand (AD) is used to describe the total spending of consumers (households), firms, and the government plus foreigners' spending on the country's consumers, firms, and government on imports.

AD = C + I + G + (X-M)

Consumer expenditure

• Consumer expenditure consists of spending by households on goods and services.
• Spending could be on necessities like food and clothing or on luxuries like travel and entertainment.

Factors That Influence Consumer Expenditure

• A rise in disposable income leads to a rise in the level of spending, especially with rich people.
• If a person/country is poor, disposable income must be spent to meet current needs.
• Saving: Defined as disposable income - consumer expenditure.
• Dissaving: Consumer expenditure may exceed income as people/countries borrow.

Income distribution

• An increase in direct taxes will mean low incomes will spend more.
• A low interest rate will increase the spendings.

Availability of credit

• If loans are easier to obtain, spending can increase.

Expectations & Wealth

If people know that their future income or jobs are safe, there will likely increase in the spending and vice versa.

Investment

• Investment is spending by private sector firms on capital goods such as factories and machinery.
• Increased consumer demand will mean firms want to buy more capital to expand capacity.
• Technology advances in tech will lead to increased productivity of capital goods.
• If business owners perceive that will improve and are optimistic that economic conditions will and improve and by Government policies, then their would be an increase in investment.

Government Spending (G)

• Government spending on goods and services, such as education and healthcare, and public goods such as defence.
• if gout wants to raise economic activity, it may increase its spending.
• Tax revenue will cause the tax to change.
• Demographic changes may come from an increase in the number of children (education) &/or of elderly (healthcare).

Net Exports (X-M)

• difference between the value of exports of goods & services and the value of imports of goods & services. (exports - imports)
• When GDP increases, demand for imports rises,
• Country's When other countries increase's their GDP ↑, our exports demand↑).
• Factors are what influences the product, such as equality & competitiveness, in this country and also the demand for exports
• Exchange is the price for one currency in terms of another.
• f exchange rate falls in value, countries' exports will be cheaper and imports more expensive so if elastic demand, export revenue, while import expenditure will fall causing net exports to fall.
• Therefore the 4 components will make up the equation: "AD = C + I + G + (X-M)".

Aggregate Demand

• microeconomics, the main determinants of demand are the price of the good, income levels, prices of substitutes & complements, consumer tastes & preferences etc. are the factors that influence these components (C, I, G, X-M) and shift the AD curve.

a simple demand

• A curve that slopes downward due to the law of demand – increase ad as price decreases,vice versa

The aggregate demand

• a curve that is also downward meaning as price level falls that real GDP increases, and vice versa due to 3 effects wealth, interest, and exports. .

Shifts in the AD curve

changes in the price level. The AD curve shifts left or right when there is a change in any non-price factor affecting A

• components C, I, G, X-M).
• ↳ consumer expenditure: and increase în in consumer confidence or a cut in income tax, vice versa
• ↳ An increase in investment aCut in corporate tax, advances in technology vice versa

When G increase, a desire to the activity increases the vice versa political standngs of parties. If the exchange of rates increase or quality etc then the income aborad vise versa.

Short run aggregate

it is he output that will be supplied in a period of time when the prices of factors of production have not had tome to adjust to changes that may shift the curve. A bakery example show how products continue with cost haven adjusted due to high demand.

Three possible causes of the positive relationship

• When firms can sell with goods at higher price in cost and wages, the profits is increased.
• Cost and item production may create in rise inncosts for material raising price levels higher.
• It higher prices are to increase the output in products curve slopes upward. The Short Run Aggregate Supply

SRAS

Decrease SRAS and increase respectively shown in this graph.

four main causes of a shift in the SRAS curve

• increased cost. or productivity decreases, shifting it.
• Changes of an curve on the right, and left.

Supply curve

shows what the product is that output curve will supply in what ways and how to change to change supply the long run aggregate shows when the real gdp shows changes with how to adapt and create.

The keynesian long-run aggregate supply curve

Explore the circular flow of income, illustrating the movement of money within an economy. This model includes output as businesses produce goods/services, income as businesses pay wages, and expenditure as households buy goods/services. Understand open vs. closed economies and their impact on this flow.