SUMMARY

SESSION 6: CIRCULAR FLOW OF INCOME

Dear visitor, Welcome to the last session of the first course. In this session, we will discuss the recirculation of income. This session will help us comprehend the role of the various economic agents and their interactions in determining the level of economic activity through the circular flow of income model.

Learning Objectives At the end of this session, students must be able to:

Appreciate the nature and role of economic agents that contribute to the generation of economic activity over time.
Understand how these agents interact through the circular flow of income model to determine the level of economic activity.
Comprehend the meaning of equilibrium in the economy and its significance.
Recognize the importance of the various leakages from and injections into the circular flow that leads to disequilibrium in economic activity.
Appreciate the link between the circular flow of income and the concept of aggregate demand.

Now read on…

6.1 Sectors of the Economy

Economies are made up of a multitude of economic agents, who perform varied roles within the economy in terms of both the production of goods and services and their consumption.

These agents may be aggregated into one of five broad sectors.

These are;

The household sector
The firm sector T
he government sector
The financial sector
The foreign sector

Let us attempt to describe these sectors and their economic roles.

6.2 The Household Sector

This sector represents an economy’s entire population.

It is common to consider the population in terms of “units” or “households.” Firms cannot produce products and services without the resources (factors of production) that households provide.

These resources consist of labor, land, and physical and financial capital.

In exchange for these factor services, firms compensate households with wages and salaries (including benefits in kind), rents and interest, profits, and dividends.

This is known as ultimate consumption expenditure. It is conclusive because it is not meant to generate additional production. Households save any income that is not spent.

6.3 The Firm Sector

The term ‘firm sector’ refers to all organizations that employ resources to produce products and services. In contrast to the domestic sector, businesses utilize and compensate for the factors of production provided by households.

In an economy, these factors of production are utilized to produce goods and services, which are then purchased by households, other firms (as intermediary commodities, such as machines and components), the government, and foreigners.

Additionally, businesses invest in new plants and apparatus, land and buildings, and other forms of productive capacity. This method of capital creation is known as fixed investment.

However, some of the products produced by businesses may not be sold and may instead be held as unsold inventory or unsold stock. In order to meet anticipated future demand, a rise in stock levels may be intentional (i.e., planned). or inadvertent (i.e., unplanned) as a result of an unanticipated decline in demand. Either way, a rise in stock prices is referred to as a stock (or inventory) investment.

Therefore, firms’ total investment expenditure consists of two components: fixed investment and stock investment.

6.4 The Government Sector

The government sector (central and local) performs a number of key roles in the determination of economic activity. It raises revenue through direct taxes levied on incomes (wages, rents, interest, profits, and dividends, as noted above) and through indirect taxes or expenditure taxes such as value-added tax, petrol duties, property taxes, etc).

The collection of taxes is necessary to meet two kinds of expenditure carried out by the government.

Spending on physical goods and services, including the wages of government employees; the purchase of military equipment; and investment in the nation’s infrastructure such as in roads, schools, and hospitals.
financing transfer payments and welfare benefits; These cover a wide range of expenditures including pensions for retired workers, unemployment benefits as well as subsidies to private sector firms and to state-owned enterprises.

Transfer payments represent a one-way flow of funds (payments) from the government for which there is no provision or exchange of goods or services in return.

Transfer payments as part of government spending are excluded from the totals for government expenditure and thus, not included for the purpose of national income accounts which measure the money value of national output.

This is because they are merely a redistribution of existing income and spending power away from those who are responsible for paying tax to those who are being subsidized.

6.5 The Financial Services Sector

By providing transmission services that channel money from savers to debtors, financial institutions, such as banks and insurance companies, play a crucial role in the economy.

These institutions serve as intermediaries in the distribution of excess funds to those who need funds for investment purposes. Without a financial sector, the economic system would cease to function rapidly.

6.6 The Foreign Sector

Exports are the products and services produced by an economy that are purchased by foreigners.

They also satisfy a portion of economic demand by selling products and services (i.e. imports).

Additionally, immigrants contribute to economic activity through the movement of capital into and out of countries. International capital transfers may take the following forms:

direct foreign investment (in plant and machinery, new factories, etc.),
debt financing and
equity capital (share purchases).

6.7 The Circular Flow of Income Model

Utilizing the circular flow of income model, the interrelationships between the five sectors determine economic activity in an economy. The circular flow of income model explains how income flows back and forth between households and businesses in an economy.

Let us make a few simplifications, however, in order to illustrate how these sectors interrelate to determine economic activity. These are the assumptions:

All income is spent.
There are only two sectors in the economy – households and firms.
There are no government or financial services sectors.
The economy is ‘closed’ in the sense that there is no trade with other countries or international capital flows.

Based on this simplistic representation of the economy, we can readily appreciate that:

the income of firms is the revenue received from the sales of goods and services to households;
the income of households is the income arising from the ownership of the factors of production (eg. wages or salaries for labor, dividends for shareholders)
Firms must pay households for the use of the factors of production, and households must pay firms for the consumption of goods and services.

This creates a circular flow of income in this closed economy as shown in the diagram below:

6.8 The Concept of Equilibrium in the Economy

The determination of equilibrium simply refers to the circumstance in which total income is spent and a particular level of economic activity is generated.

Therefore, in the simple economic system, we presumed that households spent their entire income and that no savings occurred.

For instance, if the household sector receives GHS100 billion in factor payments, households will spend GHS100 billion on firm sector products and services.

Equilibrium: national income = national expenditure A low level of economic activity is characterized by underemployment of one or more factors of production and a modest flow of products and services to households. Moreover, it suggests that the economy is not operating at its production possibility frontier.

On the other hand, a high level of activity could indicate the full employment of factor services and the production of a large quantity of products and services. The economy is at or near the limit of its production capability.

6.9 Leakages and Injections

6.9.1 Introducing the financial sector So far, we have illustrated only a very simple model of the economy. Let us now introduce the financial sector into this model and restate our underlying assumptions. We, therefore, assume again that

We have a closed economy (no foreign sector) and there is no government sector.
Households now receiving income dispose of it in two ways: a. they either spend the income on consumer goods and services (denoted as C); or b. they save a proportion of their income (this proportion is referred to as the savings ratio, denoted as S).

It therefore follows that; National income = Total consumption expenditure + Total savings Symbolically: Y =C + S Savings represent a reduction in the circular flow which can be counterbalanced by firms borrowing and spending these funds for investment purposes, channeled through the financial sector (e.g. banks).

In other words: Y = C + I where: I represent investment expenditure, including stocks (inventories) of materials, work in progress and finished but unsold goods.

6.10 Leakages and Injections

The simple circular flow model has now been extended to include savings and investment expenditures.

This now leads us to the introduction of two key concepts in the context of the circular flow: leakages and injections.

A leakage from the circular flow of income is defined as that part of national income that is not spent by households on the consumption of domestically produced goods and services. This is also sometimes referred to as a withdrawal from the circular flow.
An injection into the circular flow of income represents any expenditures on domestic goods and services originating from outside the household.

As long as (net) savings outflows are matched by firm investment expenditure decisions, economic equilibrium will be maintained.

In a sense, the actual value of savings and investment expenditures in the economy are always equal.

This implies that, over time, actual or realized savings and actual or realized investments will be identical.

Circular flow of income – with a financial sector:

It is not always the case that the level of planned investment by businesses should match the level of planned savings by households. Consequently, planned S may surpass planned I, or vice versa.

If planned I and planned S are not equal, then planned injections and leakages will not be equal, and the circular flow of income will not be in ex-ante equilibrium. For instance, if planned S is greater than planned I, unsold stocks of finished products will increase because firms’ anticipated consumption level is lower than anticipated.

By contrast,

if consumption levels are higher than expected (planned savings are lower), then firms will sell more goods than they planned and their stock levels will be lower.

The national income equilibrium condition

Planned S ≡ Planned I

6.11 Introducing the Government Sector

Other leakages and infusions into the circular flow result from government activities (via taxes and expenditure decisions, respectively). In a contemporary mixed economy, the government plays a crucial role in generating economic activity.

In lieu of privately owned businesses, the government functions as the producer of certain goods and services, such as public administration services, education, and health services, the police force, armed forces, fire brigade services, public transportation, etc.

The government must also compensate its employees and the proprietors of the other factors of production (such as capital) that it employs. The government also functions as a purchaser of goods and services.

It obtains funds through corporate, individual, and indirect taxation, and then uses these funds to purchase products and services from businesses.

Moreover, it facilitates the transfer of wealth or income from one sector of the economy to another.

By taxing employees and paying transfer payments, for instance. Incorporating the government into the circular flow of income model creates a new income leakage in the form of taxation and a new income injection in the form of government expenditure.

This is displayed below

Therefore, the equilibrium condition now changes due to the inclusion of the government sector. The national income equilibrium condition

S + T = I + G

Where T is the leakage from the circular flow of income arising from all taxation (corporate and personal) and G is the injection into the circular flow arising from government expenditure decisions

6.12 Introducing the Foreign Sector

All this while we have assumed a closed economy.

Let us now relax this assumption. When a country imports goods and services from other countries, this represents a leakage of national income from the economy (denoted as M).

When foreigners also buy our exports of goods and services this represents ‘new’ money coming into the country – an injection of income (denoted as X). We now have additional leakage and an additional injection.

Thus, the full circular flow model constitutes the following three leakages and three injections.

Leakages

Injections

Savings (S

Investment (I)

Taxes (T

Government Expenditure (G)

(G) Imports (M

Export (X)

Equilibrium in the full circular flow of income model is now given by: National income equilibrium condition

S + T + M =I + G + X

Total leakages = Total injections

The model is now complete in the sense that we are describing the equilibrium conditions under which there will be no tendency for national income to change.

6.13 The Circular Flow of Income and Aggregate Demand

Before we leave the concept of the circular flow of income, we can establish an important link between the measurement of national income, the concept of the circular flow, and aggregate demand.

It can be recalled that the level of activity in the circular flow, can be measured by total income, total expenditure or total output.

The measurements should all give the same result since they are measuring the same thing. Let’s focus on total expenditure.

Total expenditure in the circular flow of income must consist of consumer spending (C), investment spending (I), government spending (G) and net exports (X- M). total expenditure. We have, then, the identity established in the previous lecture for the calculation of national income via the expenditure method:

Total spending = C + I + G + (X − M)

We use the term aggregate demand (denoted AD) to represent this identity because it represents total spending or demand in the economy. Thus, an equilibrium level of national income exists in an economy when:

Aggregate supply (AS) = Aggregate demand (AD) where: aggregate supply represents the total output of the economy or real GDP; aggregate demand represents total spending.

Note that this refers to the demand for and supply of domestic goods and services (that is, including the value of exports and after deduction of expenditure on imports).

Hence, an equilibrium national income relates to the situation where the production plans of firms match the actual supply of goods and services needed to satisfy aggregate demand in a particular time period.

When this condition is satisfied, there is no tendency for the economy to move away from equilibrium.

6.14 The Concept of Disequilibrium

Disequilibrium in the macroeconomy occurs when the output firms plan to produce and sell is not equal to the level of production households plan to purchase. In order words, disequilibrium occurs when the total value of planned or ex-ante leakages from the circular flow of income is greater or less than the total value of planned or ex-ante injections into the circular flow. This is expressed as:

(S + T + M) > (I + G + X) or (S + T + M) < (I + G + X) AD < AS or AD > AS

When national income is in equilibrium, there will be no tendency for prices in general to rise due to excess demand since total demand is matched by the total supply of goods and services (i.e. AD = AS).

In addition, there will be no tendency for unemployment to rise owing to inadequate demand for the available supply of goods and services. However, the real world is dominated by temporary disequilibrium situations with rising and falling prices and changes in the level of employment and hence unemployment.

Thus, the role of government is to manage the economy by influencing the levels of injections and leakages.

This can be done by using a range of policy measures focusing on either the demand side of the economy or the supply side of the economy.

In this session, we have been able to identify the circumstances under which national income equilibrium and disequilibrium situations can occur.

We have also established that there is an important distinction to be made between planned or ex-ante and realized (actual) or ex-post savings and investment decisions.

Only when planned S + T + M = planned I + G + X will there be no tendency for the level of national income and therefore economic activity to alter.

Self-Assessment Questions

Exercise 1.6

Why must realize or ex-post savings equal realized or ex-post investment in an economy with only firms, households, and a financial sector? Explain your answer using a circular flow of income diagram.
Why, in such an economy, is it not necessary for planned savings to equal planned investment?
If planned savings exceeded planned investment, explain the process by which the level of national income adjusts.
In a full, circular flow of income economy (with households, firms, financial, government, and foreign trade sectors), why is it not necessarily the case that realized investment will equal realized savings but that realized injections must equal realized leakages in total?
Explain how equilibrium would be restored in the circular flow of income if there was a reduction in the overall level of planned investment expenditure.
What are the policy choices available to governments with respect to the management of aggregate demand?

SESSION: 5

CONTINUE WITH UNIT 2, SESSION: 1

CIRCULAR FLOW OF INCOME