In this comprehensive video, we’ll learn about the circular flow of income between
households, firms, government and the international economy.
We’ll contrast open and closed economies as well as examine 2, 3 and 4 sector models
of the circular flow.
Throughout we’ll be learning about the impact of leakages and injections on the circular
flow of income for an economy.
Before we jump into the topic, I’d like you to recall the four factors of production
capital enterprise, labour and land.
Each of these have a corresponding financial reward associated with them.
Capital earns interest, enterprise earns profit, labour earns wages and land earns rent.
There was an earlier video on the rewards to the factors of production that you can
review if you need a more in-depth refresh.
We also need to distinguish between product markets and resource, or factor markets.
Product markets are where goods and services are purchased from firms.
Consumer expenditure becomes business revenue for firms.
Resource, or factor markets are where businesses purchase the factors of production which are
provided by households.
This is a form of business spending which includes wages, interest, rent and profit.
Another important factor is whether we are looking at an open or closed economy.
An open economy is one that is open to international trade.
A closed economy is one that does not trade with the rest of the world.
In reality, most economies are at least somewhat open, but for the sake of simplifying reality
we will assume there are either open or closed economies for our models.
Now we’ll look at three different circular flow models, each building on the previous
one.
The first one is the two-sector economy which consists of households and firms.
In this case, the economy is closed as there is no trade with the rest of the world.
To understand the two-sector economy, let’s look at some typical transactions that take
place.
Suppose a domestic consumer purchases a good from a domestic firm.
The consumer exchanges their money for the good or service.
The consumer receives the product and the firm earns revenue.
Now let’s start building our circular flow.
We’ll start with households and firms.
Firms sell goods and services in the product market where consumers buy them.
In return for the goods and services, consumer spending becomes business revenue.
What is spent on goods and services is equal to the revenue received by firms selling those
goods and services.
Given that there is still half a blank page, we obviously have to do some more work on
completing this circular flow model.
Before we do that, let’s look at another transaction that takes place.
When firms produce the goods and services they sell to consumers, they need to employ
the factors of production to do so.
As a domestic firm purchases the factors of production from households to produce the
goods and services they sell, each of the factors of production are earning their financial
rewards.
Firms obtain the factors of production and households benefit from the rewards to the
factors of production.
Now we can finish the two-sector model.
Households offer the factors of production in the resource, or factor market.
Firms pay for these factors with the rewards to the factors of production: wages, interest,
rent and profit.
There’s one final step here that we need to discuss.
We know that consumers do not typically spend 100% of their earnings.
In the absence of government and international trade, consumers ultimately have two choices:
buy goods and services from domestic firms or save their money.
If they place their savings into the bank, there is a decrease in the amount money circulating
in the circular flow.
However, if firms borrow money from the bank and spend it to grow their business, then
there is an increase in the amount of money circulating in the circular flow.
When consumers save money, it is considered a leakage or withdrawal from the circular
flow.
Leakages are instances where money is withdrawn and not spent in consumption within the circular
flow of income.
When firms borrow and invest, it is considered an injection.
Injections represent introductions of money into the circular flow of income.
As this video progresses, we’ll add to our list of leakages and injections.
For now, in the two-sector closed economy we just have savings as a leakage and investment
as an injection.
Next up is the three-sector economy which is also closed, but includes government.
Individuals and firms are required to pay taxes to the government.
These can be direct or indirect taxes and form the total tax revenue collected by government.
In return for tax revenue, households and firms receive certain services and sometimes
goods from the government.
I’ll include all forms of government spending that benefits households and firms as government
expenditure.
Let’s shift banks outwards from this model to place government in the middle.
Both households and firms pay taxes to the government.
Households receive various goods and services from the government.
Firms receive various services, but the government may also purchase goods and services from
firms as well.
A topical example would be how the government has purchased COVID vaccines from private
pharmaceutical companies to then distribute to individual citizens.
We can now add taxation as an additional leakage from the circular flow of income because it
reduces the flow of expenditure between households and firms.
Government spending is considered an injection as it can increase the level of spending that
occurs between households and firms.
We now get to our most complicated model which is the open four-sector economy.
This includes global trade.
Suppose a firm from the US wants to buy leather gloves from a factory in Pakistan.
This would increase the level of import spending of the United States.
Now suppose a consumer in France wants to purchase an American pair of jeans.
This would increase the level of exports from the United States.
How would these two transactions impact the circular flow of income in the United States?
We’ll need to shrink this image down a bit to make room for trade with the rest of the
world.
As you can imagine, by selling more goods and services overseas the American economy
will see an injection of export revenue being earned by domestic firms.
However, it will be counterbalanced by a leakage, more specifically the amount of money being
spent on imports purchased from foreign firms.
The American company purchasing leather gloves from a Pakistani factory will be a leakage
from the American economy and an injection into the Pakistani economy.
When the French consumer purchased jeans from an American company, this is a leakage from
the French economy and an injection into the American economy.
That completes our list of leakage and injections.
In this final four-sector open model we have all three leakages present – savings, taxation
and import expenditure.
We also have all three injections – investment, government expenditure and export revenue.
If you’ve made it this far you’ve picked up a lot on the circular flow.
You should be able to understand each of the key points listed here.
If you have any questions or comments, leave them below and let’s try and answer them
together.
That’s us done for now and I will see you in the next one!