Circular Flow: income and expenditure - PowerPoint PPT Presentation


PPT – Circular Flow: income and expenditure PowerPoint presentation | free to view - id: 213afe-ZDc1Z


The Adobe Flash plugin is needed to view this content

Get the plugin now

View by Category
About This Presentation

Circular Flow: income and expenditure


The vast majority of the nations in the world have economies that are market ... Resource allocation is unbelievably complex in a modern economy with thousands ... – PowerPoint PPT presentation

Number of Views:475
Avg rating:3.0/5.0
Slides: 20
Provided by: richard1006


Write a Comment
User Comments (0)
Transcript and Presenter's Notes

Title: Circular Flow: income and expenditure

(No Transcript)
  • This week we will discuss market economies
  • The vast majority of the nations in the world
    have economies that are market based as opposed
    to centrally planned (eg the former Soviet Union
    or North Korea today)
  • Markets are so prevalent some argue they are
    natural institutions others simply take the
    point of view they are just one example of a
    particular system of social organization chosen
    by society over other alternatives

Markets allocate resources!
  • One of the basic problems in society is to
    ALLOCATE scarce resources-some say this defines
    the economic problem
  • We say there are limited or scarce resources
    which need to be assigned to unlimited wants by
  • Eg. should labour (work) be assigned to produce
    lumber or hamburgers?
  • Resource allocation is unbelievably complex in a
    modern economy with thousands of goods and
    millions of people
  • A market system has turned out to be the most
    durable and stable forms of social organization
    to carry out the allocation of resources despite
    lots of tries at alternatives throughout history

What exactly are markets?
  • Markets are older than recorded human history
  • Originally they were places were individuals
    exchanged one good for another (barter) by
    haggling over the terms of exchangeeg. 1 loaf of
    bread for 2 apples
  • Modern markets have many of these features
    although a) typically goods exchange for money in
    modern economies not other goods, and b) markets
    are often not organized in a specific time or
    place (eg. The currency markets run 24 hours a
    day and occur in cyberspace-not at a particular
    geographic place)

What do you need to have a market?
  • First, markets need the Rule of Law to ensure
    that an exchange is not subject to fraud,
    misrepresentation, or other forms of
    dishonestymarkets need a minimum level of trust
    between parties which the legal system usually
    provides (but not alwayseg. drug markets)
  • Second, markets only work if sellers can legally
    transfer the property right of the good to the
    buyeryou need well defined property rights so
    that exchange can take place
  • Third, the cost of buyers and sellers conducting
    an exchange cant be too highwe say the
    transactions costs must be reasonable for a
    market to exist
  • Fourth, markets need to be sufficiently deepby
    this we mean there must be enough buyers and
    sellers of a similar good (or service) to make it
    worthwhile to create and operate a market

Government the mixed economy
  • Most modern economies are Mixed Economies that
    is only part of what is economic activity occurs
    within marketsthe other major economic
    institution is Government
  • Government accounts for about 30-60 percent of
    economic activity
  • Government usually is responsible for defense,
    public health, police, health, education, social
    security, and a variety of other public goods
  • Governments do what markets cant do well
    although there are some sectors (eg airlines or
    electricity) which are public in one economy but
    market based in others

Market participants
  • Markets usually bring together three sets of
  • Consumers of the goods and services
  • Organizations called firms that are responsible
    for production (transforming inputs into useful
    outputs)firms can be small or large (the modern
  • Suppliers of factor services who sell to the
    firms --these are individuals selling labour
    services and owners of financial resources who
    provide firms with capital
  • Every individual usually plays at least two and
    sometimes three roles in a market system they
    are a consumer, they are a supplier of factor
    services (labour) and sometimes they manage or
    own a firm

Rules of the Market
  • Most of the basic rules of the market are
    provided by government (who set the legal
    framework) but this is not always the case (eg
    black markets)
  • Government also provides a monetary system which
    sets the legal unit of account (money) in which
    contracts are set
  • Individual firms, consumers and factor suppliers
    are free to negotiate the terms of exchangeie
    what price, and how much, and what to buy or sell

Modern market economies
  • The modern market economy is arguably the most
    amazing form of social organization ever
  • Literally millions of voluntary transactions
    occur every day between millions of unrelated
  • Market dont do all resource allocation however
    A lot of resource allocation occurs A) within
    firms B) by government bureaucracy and C) by
    familys or other closely related persons acting
    outside of an organized market or firmtrust is
    very important in these cases
  • Typically the higher the level of average income
    or level of economic development the larger is
    the formal market sector relative to other forms
    of resource allocation

Measuring economic activity the Circular flow of
income and expenditure
  • Given the organization of the modern economy most
    relationships between the three principal actors
    involves the exchange of money for a good or
  • This sets up a natural flow of money that has
    been referred to as the circular flow
  • Money flows from consumers to firms to input
    suppliers who in turn acting as consumers then
    spend it on firms etc. etc.

Circular Flow income and expenditure
Income versus Expenditure
  • In the circular flow diagram we see how money
    flows from households as buyers of goods to firms
    (ignore government for moment)
  • Money also flows from the firms to household this
    time as payment for the provision of factor
    inputs (labour and capital)
  • This provides the basis for the way economists
    think about the interactions between different
    parts of the economy and the measurement of
    economic activity

How to measure economic activity?
  • This flow naturally suggests two ways in which to
    measure economic activity in money terms
  • Expenditurewe can measure economic activity as
    the money is spent in the economy on different
    goods and services
  • Incomewe can measure economic activity by adding
    up the value of all the money paid by firms to
    their factor suppliers
  • GDP(Gross Domestic Product) or National Income is
    what we call these two measures of total economic
    activity in an economy

Two sides of same coin?
  • The expenditure approach and the income approach
    are really ways of doing the same thing since in
    a market system an expenditure or cost by one
    party must be a receipt or an income of another
  • On the income side we usually classify income
    into three categories wages, profits and
    interest, and rents (comes from Marxs
    classification of factors of production as
    either labour, capital or land)
  • On expenditure side we usually break it down into
    spending on consumption, investment, and

How to incorporate Government?
  • Government in a market economy complicates the
    picture a bit (or a lot)
  • Most governments produce goods and services that
    are provided to their citizens either free or
    with limited user charges
  • To produce they must pay the people who work for
    them and thus they need money
  • The government pays for these services by taxing
    either at the point of expenditure (eg a sales
    tax) or at the point at which income is received
    (eg an income tax)

Summing Up Thus Far
  • The circular flow framework in a market based
    economy leads to an important identity
  • GDPTotal ExpenditureConsumptionInvestmentGover
    nment Spending Total IncomesWagesProfit
  • We refer to money or NOMINAL GDP which is the
    natural dollar measure of these expenditures
    where dollars are used as money in other
    countries say Japan nominal GDP would be measured
    in Yen, in Germany it would be Euros, Mexico
    pesos etc. etc.

  • One often makes reference however to an
    alternative concept which is REAL or CONSTANT
    dollar GDPthis is to correct for problem of
  • Nominal GDP can go up either because people
    bought more cars and houses etc. or because the
    dollar price of cars and houses went up. When
    all prices tend to go up over time this is
    referred to as INFLATION
  • To take out the effect of inflation on the real
    changes in GDP over time ( ie what the economy
    actually produced) we divide NOMINAL or MONEY GDP
    by an INDEX of all the prices in the economy
  • The most popular index of prices is the Consumer
    Price Index reported every month in the papers
  • In a global context correcting for inflation is
    very important because inflation rates of
    different monies (currencies) can be very

Where to find these numbers?
  • A useful place to easily get numbers on the
    GROWTH of GDP and rate of INFLATION (ie how fast
    prices are rising on an annual basis) is the back
    of the Economist magazine every week.
  • This week for example inflation is highest in
    Venezuela at 14.2 while Japan has deflation
    (falling prices) of -0.8
  • Growth is highest in Latvia at 11.4 and GDP
    growth is lowest in Italy at 0.1 (amazingly
    there is actually no economy actually shrinking
    at this point ie negative GDP growth)

Author Richard Harris
  • last revision September 8-2008
  • for fall 2008 Ec102 Simon Fraser University
  • do not distribute without authors permission