Cont

PART 4 FUNDAMENTAL MACROECONOMIC CONCEPTS Chapter 8 The circular flow

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-1

Lecture plan
• The exchange flow between households and the

business sector
–

The two-sector economy

• •

The exchange flows with financial markets
–

The financial sector and the three-sector economy

The exchange flows between households, businesses and government
–

The government sector and the four-sector economy The overseas sector and the five-sector (open) economy

•

Exchange flows with other countries
–

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-2

The circular flow of goods and money
• In a capitalist/mixed economy money is used to:
– – –

Buy and sell goods and resources in markets Pay and collect taxes Borrow and lend in financial markets

• The ABS structures the Australian national

accounts around the five sectors of the economy, that is:
– – – – –

Businesses Households Financial Government Overseas

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-3

The two-sector model of the economy (households and firms)
• The households (consumers)
–

– – –

Require goods and services to satisfy their personal wants Own all resources (i.e. labour, capital, land, enterprise) Sell resources to businesses Gain income (e.g. wage, interest, rent, profit) from such sales
Uses resources provided by households to produce goods and services Sells those goods and services for income

• The firms/business sector (producers)
–

–

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-4

The two-sector model of the economy
• Assumptions
–
– –

–

Businesses are the only producers All goods and services are sold to consumers Consumers spend ALL their income on goods and services There are no resource inventories (no stockpiles)
Total demand (expenditure) = total supply (output) The economy will always be in equilibrium

• Therefore:
–

–

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-5

The two-sector model of the economy
• Two groups of decision makers
– –

Households (sell their resources) Firms (sell goods and services)

• Interaction between the two sectors through

markets:
–
–

Resource (factor) markets Product markets

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-6

The two-sector model of the economy

Figure 8.1
Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-7

The two-sector model of the economy
• In the basic circular flow model:

O

= Y

=

E

Where: O = output (production) Y = income E = expenditure (demand)

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-8

The financial sector
• Saving (S): the part of the income that is not spent

(leakage) • Total income = consumption spending + saving
Y=C+S

• Investment (I): the part of production that is not

used for current consumption (e.g. capital goods)
Total income (Y) = C + I

• Investment is an injection. If:
S > I, the economy contracts S < I, the economy expands S = I, the economy is in equilibrium

• The financial sector acts as an intermediary

between lenders and borrowers

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-9

The government sector
• Government taxation (T) reduces households’

disposable income and business funds Taxation (T) is a leakage (outflow) • Government spending (G) includes expenditure on collective goods and services and on goods and services provided by the business sector, plus transfer payments (social security payments)

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-10

The external sector
• The main inflows of funds generated by the

overseas sector include:
– –

Exports of goods and services to other countries by the home economy’s business Foreign investment undertaken in Australia and income payments to Australian residents (e.g. interest, dividends)

• Because these activities earn income for the

Australian economy, they are an injection of funds into the circular flow

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-11

The external sector
• Australia’s business relations with the rest of the

world also determine outflows of funds for purchases of imported goods and services by households, government and the business sector, for Australian investment overseas, and for income payments to overseas residents • Income spent abroad in this way is seen as a leakage, thereby lowering the flow of domestic spending

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-12

The modified five-sector model of the economy
It is a five-sector model of the economy:
•
• • • •

The household sector The firms sector The government sector The financial sector The external (overseas) sector

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-13

The five-sector model of the economy

Figure 8.2
Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-14

The open economy
• Total leakages (outflows) are S, T and M

• Total injections are I, G and X
• The impact of total leakages/injections on the

economic activity is as follows: S + T + M = I + G + X equilibrium S + T + M > I + G + X contraction S + T + M < I + G + X expansion

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-15

Summary
• The two-sector circular flow of income is a basic

model of the economy which shows the household and business sectors and the resource and product markets • This model ignores the existence of the financial, government and overseas sectors • According to this model outflows (leakages) are equal to inflows (injections) and the economy will always be in a state of equilibrium

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-16

Summary
• The five-sector model of the circular flow of income

includes households, firms, financial, government and external sectors • The model shows how equilibrium or disequilibrium occurs in the economy, depending on the net difference between total leakages and total injections

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-17

Summary
• An open economy represented by the five-sector

circular flow model is illustrated in a flow diagram, to show:
(a) the flow of resources and of goods and services in exchange for money (b) outflows of savings into the financial sector where they are converted into investment (c) outflows of taxes collected and used by the government sector for expenditure on collective goods and services plus transfer payments (e.g. social security payments) (d) flows of goods, services and money between the domestic economy and the rest of the world

Copyright © 2011 McGraw-Hill Australia Pty Ltd PPT slides to accompany Economics for Business 4e by Fraser, Gionea & Fraser

8-18