1.

8: The Level of Overall Economic Activity

 Describe, using a diagram, the circular flow of income between households and firms in a closed economy with
no government.
- The diagram is called the “circular flow of income model”
- The model illustrates a “closed economy”, meaning:
1. Has no links with countries (‘closed’ to international trade)
2. Model of economy with no government: it assumes that the only
decision makers are consumers and firms; both in square boxes.
 The consumers and firms are linked together through two
markets: product market and resource market, shown in
diamonds
 Households or consumers, are the owners of the 4 factors of
production: land, labour, capital and entrepreneurship
 Firms buy the factors of production from resource market
and use them to buy to produce goods and services
 Then they sell the good and services to consumers in product
markets
 Therefore, we see in a clockwise direction of factors of production from households to firms, and of goods
and services from firms to households

 Identify the four factors of production and their respective payments (rent, wages, interest and profit) and
explain that these constitute the income flow in the model.
- In the counterclockwise direction, there is a flow of money used as payment in sales and purchases
- Income of households: when households sell their factors of production to firms, these receive money in the form
of
1. Rent: for land
2. Wages: for labor
3. Interest: for capital
4. Profit: for entrepreneurship
o Household expenditure: the payments that households make to buy goods and services
o Costs of production: the payments that firms make to buy factors of production
o Revenues: the payments they receive by selling goods and services
o Money flows: all payment flows

 Outline that the income flow is numerically equivalent to the expenditure flow and the value of output flow
- the model demonstrates an important principle: the income flow (from firms to households) = expenditure
flow (from households to firms)
o Circular flow of income: when the household incomes coming from the sales of all the factors of production equals
to the expenditure by households on goods and services
o Value of output flow: when the two flows (income flow and expenditure flow) must be equal to the value of goods
and services, or the value of total output produced by the firms
- The reason behind this: if each good and service is multiplied by its respective price, we obtain the value of
each good and service, and adding them all up we arrive at the value of total output. This value is the same as
consumer expenditure, since spending is equal to each item they buy multiplied by its price.
 The circular flow of income shows that at any given time period, the value of output produced in an economy is
equal to the total income generated in producing that output, which is equal to the expenditures made to
purchase that output
 Describe, using a diagram, the circular flow of income in an open economy with
government and financial markets, referring to leakages/ withdrawals
(savings, taxes and import expenditure) and injections (investment,
government expenditure and export revenue).
- Leakages and injections are paired together so that what leaks out of the
flow can come back in as ab injection

- The most important pairs are the following:

Leakages Injections
Saving Investment
Taxes Government spending
imports Exports

 Saving and investment

o Saving: is the part of consumer income that is not spent but saved
o Investment: spending by firms for the production of capital goods
- When households save part of their income, this represents a leakage because income is not spent to buy
goods and services. Households place their savings in financial markets (bank accounts, purchases of stocks
and bonds, etc.)
- Firms obtain funds from financial markets (through borrowing, issuing stocks and bonds, etc.) to finance
investment or produce capital goods. These funds flow back into expenditure flow as injections
- Therefore, saving leak out of the flow of consumer expenditures, and after passing through financial markets
is injected back into expenditure flow as investment

 Taxes and government spending

- Taxes and government spending are connected together through the government
- Households pay taxes to the government; this is a leakage become income is not spent on goods and services
- The government uses the tax fund to finance government expenditures (on education, health, defense, etc.)
and this spending is an injection back into the expenditure flow.

 Imports and exports

o Imports: goods and services produced in other countries and purchased by domestic buyers
o Exports: are goods and services produced domestically and purchased by foreigners
o Open economy: when an economy has international trade through imports and exports
- Imports and exports are linked together through ‘other countries’
- Imports are a leakage they represent household expenditure that leak out as payments to other countries
- Exports are injections because they are a spending by foreigners to buy goods and services produced by
domestic firms
 Explain how the size of the circular flow will change depending on the relative size of injections and leakages.
- In real world, leakages and injections are unlikely to be equal, and this has important consequences for the size of
the circular flow
- If the leakage is larger than the injection, then the size of the circular flow becomes smaller:
1. Part of the household income that leaks as savings into financial markets does not come back
2. The result is that
i. fewer goods and services are purchased
ii. firms cut back on their output and buy fewer factors of production
iii. unemployment increases since firms don’t hire as much employees anymore
iv. household income is reduced
- If the leakage is smaller than the injection, the size of the circular flow becomes larger:
1. The expenditure flow increases since the injection is larger than the leakage
2. The result:
i. More goods and services are purchased
ii. firms produce more output and buy more factors of production
iii. employment increases since firms hire more employees to produce more goods
iv. household income increases