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Macroeconomics: circular flow of the economy

Importance of the circular flow:
  • In a modern market economy, multiple agents interact with each other in the marketplace to determine the supply and demand of goods and services.
  • These interactions can be represented by a model showing the flow of money that renders these exchanges of products and resources possible.
There are five main contributors to the economic activity of a nation:
  • Households: demand goods and services in the product market, and supply factors of production in the factor market. They pay taxes, and receive transfer payments and public goods from the government.
  • Firms: domestic firms produce a large share of the goods and services in the product market. Firms form the demand in the factor market, employing resources from households. Firms also pay taxes and are able to use public goods provided by the government. Some firms also sell their output to foreign households and demand resources from foreign households.
  • Government: collect taxes from both households and firms, redistribute income via transfer payment and provides public goods and services. Furthermore, it also provides the legal framework that protects property rights of individuals and firms.
  • Foreign Sector: both domestic households and firms demand goods and services from foreigners. Moreover, foreigners also demand some of a nation's output.
    • Imports takes money away from the domestic circular flow system.
    • Exports brings money into the domestic circular flow system.
  • Banking Sector: the banking system facilitates the flow of capital from households to firms.
    • Money saved by households takes money away from the circular flow, as the money is not spent on either goods or services.
    • Money lent to firms for investments brings money into the system. Firms will spend this extra money on new capital, increasing employment and output.
    • Banks simply the process for both lenders and borrowers.
There are two market types in a circular flow:
  • Resource (factor)  market: the market in which businesses use to buy resources such as labor and capital provided by the households.
    • Labor market: households provide labor to firms in exchange of a wage.
    • Capital market: households who save provide financial capital to banks whom can then make loans to firms. Households receive payments in the form of interest. 
  • Product market: the market in which households demand goods and services produced by firms.
A nation's economy experiences constant leakage and injection of money:
  • Injection creates more spending which in turn creates more production and employment, thereby increasing the size of a nation's economy.
  • Leakage reduces the amount of money in an economy, which then reduces production and employment. This reduces the size of a nation's economy.
  • Government:
    • Leakage: taxes collected from firms and households reduce their consumption.
    • Injection: the government provides public goods, and transfers payments which redistribute the nation's income.
  • Banking Sector:
    • Leakage: money saved in banks by households and firms.
    • Injection: money borrow from banks by both households and firms to finance spending on consumer and capital goods.
  • Foreign Sector: 
    • Leakage: imports spending by domestic households and firms on foreign products. The money spent is not going to benefit domestic firms and thereby domestic employment.
    • Injection: export  revenues from the sell of products to foreigners creates a greater demand for domestic products, increasing the nation's total output.
Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 59-63.
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