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The circular flow of money model for students of BA1 This article is about the determination of macroeconomic phenomena, equilibrium, national income, growth in national income price inflation and unemployment. This article will focus on national income, equilibrium and the circular flow of money model. National income, output, and expenditure are generated by the activities of the two most vital building blocks of an economy, households and firms, as they engage in mutually beneficial exchange. In a simple economy where there are only firms (producers) and households (consumers), the primary economic function of households is to supply firms with required factors of production - land, labour, capital and enterprise. These are supplied in return for a reward (land receives rent, labour receives a wage, capital receives interest, and enterprise receives a profit). Therefore in a simple economy: Households pay for goods and services they consume with the income they receive from selling their factors; and Firms supply goods and services to households – utilising the four factors of production. In this situation the circular flow of is neither increasing nor decreasing, and equilibrium is where income (Y) equals consumption (C). In the macro economy, the circular flow fluctuates as injections (J) or withdrawals (W) occur. An injection will increase the flow, and a withdrawal will do the opposite. Injections Injections are recognised as additional expenditure that are from outside the circular flow. For example, firms may purchase (invest in [I]) capital goods, such as machinery, from other firms, and this spending is an injection into the circular flow. Government investment (G) in public and merit goods like defence and policing, education, and healthcare boosts the circular flow. And finally, foreign households and firms buy domestic products, called exports (X), and this brings money from overseas into the circular flow. Withdrawals Withdrawals reduce the circular flow. Households may choose to save (S) some of their income (Y) rather than spend it (C). In addition to saving (S), households pay taxes (T) to the government, removing money from the circular flow. Finally, households spend some of their income (Y) on imports (M) – goods from abroad, so money flows overseas; and out of the circular flow. Equilibrium For equilibrium in a macro economy to occur, planned injections need to be equal to planned withdrawals: Equilibrium is where: Injections (J) = Withdrawals (W) This is also sometimes written as Equilibrium (E) = C + I + G + (X – M) National Income If injections (J) are greater than withdrawals (W), then more money is coming into the circular flow than is leaving it and national income will rise. The opposite happens when withdrawals and greater than injections; national income falls. Greece - the circular flow of money and equilibrium Greece became the epicenter of Europe’s debt crisis after the Wall Street crash in 2008. With global financial markets still reeling, Greece announced in October 2009 that it had been understating its deficit figures for years, raising alarms about the soundness of Greek finances. Suddenly, Greece was shut out from borrowing in the financial markets. By the spring of 2010, it was veering toward bankruptcy, which threatened to set off a new financial crisis. To avert calamity, the so-called troika — the International Monetary Fund, the European Central Bank and the European Commission — issued a number of international bailouts. The bailouts came with conditions. Lenders imposed harsh austerity terms, requiring deep budget cuts (reduction in G) and steep tax rises (increase in T). The money was supposed to buy Greece time to stabilize its finances and quell market fears that the euro union itself could break up. However, the bailout money mainly goes toward paying off Greece’s international loans, rather than making its way into the economy. And the government still has a staggering debt load that it cannot begin to pay down unless a recovery takes hold. Many economists, and many Greeks, blame the austerity measures for much of the country’s continuing problems. If we think back to the simple circular flow of money model, and injections (J) and withdrawals (W), by reducing government investment (G) and increasing taxes (T) we have created a situation where national income falls as J < W (injections are smaller than withdrawals). If national income falls, households are less likely to consume (C), firms are reluctant to invest (I), which may that they have to reduce the amount they spend in income (Y) which potentially causes a recession. While the bailout has helped, Greece’s economic problems haven’t gone away. The economy has shrunk by a quarter in five years, and unemployment is above 25 percent. Questions 1 In the circular flow model of the economy, the level of national income will always reach equilibrium because: A. Injections and withdrawals are always equal. B. Withdrawals are a function of the level of income. C. Governments will change taxes and expenditure to ensure equilibrium. D. Expenditure equals income. 2 Which of the following is least likely to result in a fall in household consumption? A. An increase in interest rates B. A reduction in the availability of credit C. An increase in the rate of inflation D. An increase in the rate of income tax 3 All of the following government policies would tend to raise national income over time EXCEPT which ONE? A. Increased expenditure on the economic infrastructure. B. Tax cuts to encourage higher demand from consumers. C. Policies to encourage the training of labour. D. Financial incentives to encourage personal and corporate saving. Answers 1 B. Withdrawals are a function of the level of income. 2 C. An increase in the rate of inflation People tend to buy goods now if they think the price is going to increase in the long run 3 D. Financial incentives to encourage personal and corporate saving.
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