(2) Households are the ultimate owners of the firms-shareholders live in houses too-and thus any profits that firms make are returned to households. Household income comes from two main sources: (1) Households contain workers who sell their time to firms and receive wages in return. Thus there is a circular flow of income in an economy as a whole. But this income comes from firms, and they get their income from the spending of households. The spending by households on goods and services is funded by the income that households earn. One linkage is between income and spending. By tracking these flows, we can understand the links between different markets by understanding these links, we gain insight into the functioning of an economy. This is true for all transactions: as individuals and firms buy and sell goods and services, money flows among the different sectors of the economy. The idea is the same either way.) There is a flow of money from you to the seller and a flow of goods or services from the seller to you. (You might literally hand over dollar bills and receive a CD, or you might enter a credit card number into a website entitling you to a download. When you purchase a piece of computer software, you give money to the seller, and the seller gives the software to you. There are two sides to every transaction. This relationship lies at the heart of macroeconomic analysis. From a simple version of the circular flow, we learn that, as a matter of accounting, gross domestic product (GDP) = income = production = spending. The circular flow of income describes these flows of dollars. Toolkit: Section 31.27 "The Circular Flow of Income"Īs individuals and firms buy and sell goods and services, money flows among the different sectors of the economy. To understand the circular flow, recall our working definition of economic activity: “goods and services produced for sale.” So far, we have focused on production. One of the most important is called the circular flow of income The money flows among the different sectors of an economy as individuals and firms buy and sell goods and services. We need frameworks to help us make sense of the data that we gather.Įconomists use many different kinds of frameworks to make sense of an economy. Measurement of the economy tells you what has happened, but it tells you neither why it happened nor what it means. As yet, though, you do not know anything about either the causes or the consequences of these events. You also report that there was a recent increase in the price level. You report back to the International Monetary Fund (IMF) team that production has been declining in recent years. Looking at some basic measurements of the economy has allowed you to be more concrete about the problems in Argentina. This is Q14 from the 2017 NSW HSC Eco exam.After you have read this section, you should be able to answer the following questions: As a result, GDP is likely falling, unemployment is on the rise and prices and probably dropping (lower inflation). More money is being removed (or withdrawn) from the economy than is being pumped into it. When the value of leakages EXCEEDS the value of injections, the economy is slowing. ![]() ![]() As a result, gross domestic product (GDP) is likely rising, unemployment is likely falling and prices are probably on their way up (higher inflation). More money is flowing into the economy than is leaving. ![]() When the value of injections EXCEEDS the value of leakages, the economy is growing. The economy is neither growing nor slowing it’s stable. When the value of injections EQUALS the value of leakages, the economy is in a state of equilibrium. Let’s look at the relationship between injections and leakages. The leakages are Savings (S), Tax (T) and Imports (M). The injections are Investment (I), Government Spending (G) and Exports (X). In terms of the Five Sector Model, we have injections (money flowing into the economy) and leakages (where money leaves the economy).
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