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Circular Flow Gemma Kotula Christopher Newport University 1 Center for Economic Education Lets look at some definitions Market – any place where buyers and sellers come together Revenue – money earned from the sale of goods & services Interest – additional money owed when taking out a loan Wages – money paid for labor (workers) Income – money earned by performing labor (working) Rent – money paid for the use of land or property 2 Businesses Households 2 Decision Makers 3 Product Market Market for Goods & Services Businesses Households 2 Decision Makers 2 Markets Resource Market (Factor Market) Market for Factors of Production 4 Product Market Spending $ Market for Goods & Services $ Goods and Services Bought by Consumers Businesses $ Households Flow of Dollars Flow of Goods and Services Resource Market (Factor Market) Market for Factors of Production 5 Revenue $ Spending $ Market for Goods & Services $ $ Product Market Goods and Services Bought by Consumers Goods and Services Sold By Firms Businesses $ $ Households Flow of Dollars Flow of Goods and Services Resource Market (Factor Market) Market for Factors of Production 6 Revenue $ $ $ Product Market Spending $ Market for Goods & Services Goods and Services Sold By Firms Goods and Services Bought by Consumers Businesses $ $ Households Decision Makers Markets $ Land, Labor, Capital, Entrepreneurship and Technology Flow of Dollars Flow of Goods and Services Flow of Factors of Production $ Resource Market $ (Factor Market) Market for Factors of Production Wages, Rents, and Interest 7 Revenue $ $ $ Product Market Spending $ Market for Goods & Services Goods and Services Sold By Firms Goods and Services Bought by Consumers Businesses $ $ Households Decision Makers Markets $ Land, Labor, Capital, Entrepreneurship and Technology Flow of Dollars Flow of Goods and Services Flow of Factors of Production $ Resource Market $ (Factor Market) Market for Factors of Production Wages, Rents, and Interest Land, Labor, Capital, Entrepreneurship and Technology $ $ $ Income 8 Even though we have worked quadrant to quadrant we now have a complete… 9 Revenue Product Market Spending Market for Goods & Services $ $ $ $ $ $ Businesses Decision Makers Markets Households Flow of Dollars $ $ $ Resource Market $ $ (Factor Market) $ Market for Factors of Production Wages, Rents, and Interest Income 10 Even though we have worked quadrant to quadrant we now have a complete… 11 Product Market Market for Goods & Services Goods and Services Bought By Goods and Services Sold By Firms Consumers Businesses Decision Makers Markets Households Flow of Goods and Services & Flow of Factors of Production Land, Labor, Capital, Entrepreneurship & Technology Resource Market Land, Labor, Capital, Entrepreneurship & Technology (Factor Market) Market for Factors of Production 12 • Putting all flows together shows us that they are indeed circular. • Therefore the dollars that flow around counterclockwise (in this example) are equal to… • The goods, services, and factors of production that flow around clockwise (in this example). 13 Revenue Spending Product Market Market for Goods & Services $ $ $ $ Goods and Services Bought By Goods and Services Sold By Firms $ $ Consumers Businesses $ $ Land, Labor, Capital, Entrepreneurship & Technology Decision Makers Markets Flow of Dollars Flow of Goods and Services & Flow of Factors of Production Resource Market Households Land, Labor, Capital, Entrepreneurship & Technology (Factor Market) $ Wages, Rents, and Interest $ $ $ Market for Factors of Production Income 14 Does the Circular Flow Leak? • Classical economists were guided by Say’s Law. • In a simple economy Say’s Law states that by producing goods and services, firms create a total demand for goods and services equal to what they have produced. • Or more simply, supply creates its own demand. So yes there may be leaks! 15 But it also gets “pumped up”! • Households don’t spend all of their income. Rather, some of their income goes to savings (leakage) or to pay taxes (leakage). • Households are not the only spenders in the economy. Rather, firms also spend money on capital goods (injection) and the government also spends money on final goods and services (injection). • In addition to markets for goods and markets for resources, there is also a loanable funds market where household saving is made available to firms and the government. 16 • Total spending in the circular flow will equal total output in the circular flow if and only if leakages in the economy are equal to total injections. 17 Total Spending = Total Output Or… what goes around comes around! 18 Government has a role in the economy… • However, the government’s role in the economy is dependent on the taxes it charges (and firms and households pay). • And that role includes providing goods and services to those same firms and housholds! 19 Spending Revenue Product Market $ $ $ Market for Goods & Services $ Government Provides goods and services to Households and receives taxes in return $ Businesses $ Households Government Provides goods and services to Firms and receives taxes in return $ $ $ $ $ $ Resource Market (Factor Market) Wages, Rents, and Interest Market for Factors of Production Income 20