<<

. 46
( 126 .)



>>


THE CIRCULAR FLOW OF SPENDING, PRODUCTION, AND INCOME
Enough definitions. How do these three concepts”domestic product, total expenditure,
and national income”interact in a market economy? We can answer this best with a National income is the
rather elaborate diagram (Figure 1 on the next page). For obvious reasons, Figure 1 is sum of the incomes that all
called a circular flow diagram. It depicts a large tube in which an imaginary fluid circu- individuals in the economy
earn in the forms of wages,
lates in the clockwise direction. At several points along the way, some of the fluid leaks
interest, rents, and profits.
out or additional fluid is injected into the tube.
It excludes government
To examine this system, start on the far left. At point 1 on the circle, we find consumers.
transfer payments and is
Disposable income (DI) flows into their pockets, and two things flow out: consumption calculated before any de-
(C), which stays in the circular flow, and saving (S), which “leaks out.” This outflow de- ductions are taken for
picts the fact that consumers normally spend less than they earn and save the balance. The income taxes.
“leakage” to saving, of course, does not disappear; it flows into the financial system via
Disposable income (DI)
banks, mutual funds, and so on. We defer consideration of what happens inside the finan-
is the sum of the incomes
cial system to Chapters 12 and 13. of all individuals in the
economy after all taxes
have been deducted and
all transfer payments have
been added.
More detailed information on these and other concepts is provided in the appendix to this chapter.
2




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 2
156 The Macroeconomy: Aggregate Supply and Demand



F I GU R E 1
Expenditures Rest of the
The Circular Flow of World
Financial System C+
(I) l
C)
Expenditures and (
ion




t
en
Income pt C




tm
2 )
m
su (G



Sav
)




es




+
(IM )
s




n




Inv




l+
rts s (X




Co
ing




se
3 o
Impxport




ha




G
(




rc
S)
E




Pu
Investors 4




nt
me




C+
er n




I + G + (X “ IM)
Gov
Consumers
1

Government
Di s
po




Firms


Transfe
sa




Taxes
5
bl e




(produce the
In




domestic product)
om
c




rs
e 6
(D
I)
Y)
Gross me (
co
National In
Income



The upper loop of the circular flow represents expenditures, and as we move clockwise
to point 2, we encounter the first “injection” into the flow: investment spending (I). The
diagram shows this injection as coming from “investors””a group that includes both
business firms and home buyers.3 As the circular flow moves past point 2, it is bigger than
it was before: Total spending has increased from C to C 1 I.
At point 3, there is yet another injection. The government adds its demand for goods
and services (G) to those of consumers and investors (C 1 I). Now aggregate demand has
grown to C 1 I 1 G.
The next leakage and injection come at point 4. Here we see export spending entering
the circular flow from abroad and import spending leaking out. The net effect of these two
forces may increase or decrease the circular flow, depending on whether net exports are
positive or negative. (In the United States today, they are strongly negative.) In either case,
by the time we pass point 4, we have accumulated the full amount of aggregate demand,
C 1 I 1 G 1 (X 2 IM).
The circular flow diagram shows this aggregate demand for goods and services arriv-
ing at the business firms, which are located at point 5. Responding to this demand, firms
produce the domestic product. As the circular flow emerges from the firms, however, we
rename it gross national income. Why? The reason is that, except for some complications
explained in the appendix,
National income and domestic product must be equal.
Why is this so? When a firm produces and sells $100 worth of output, it pays most of
the proceeds to its workers, to people who have lent it money, and to the landlord who
owns the property on which the plant is located. All of these payments represent income
to some individuals. But what about the rest? Suppose, for example, that the firm pays
wages, interest, and rent totaling $90 million and sells its output for $100 million. What
happens to the remaining $10 million? The firm™s owners receive it as profits. Because
these owners are citizens of the country, their incomes also count in national income.4



You are reminded that expenditure on housing is part of I, not part of C.
3


Some of the income paid out by American companies goes to noncitizens. Similarly, some Americans earn
4

income from foreign firms. This complication is discussed in the appendix to this chapter.




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Chapter 8 157
Aggregate Demand and the Powerful Consumer



Thus, when we add up all the wages, interest, rents, and profits in the economy to obtain
the national income, we must arrive at the value of output.
The lower loop of the circular flow diagram shows national income leaving firms and
heading for consumers. But some of the flow takes a detour along the way. At point 6, the
government siphons off a portion of the national income in the form of taxes. But it also
adds back government transfer payments, such as unemployment compensation and So- Transfer payments are
sums of money that the
cial Security benefits, which government agencies give to certain individuals as outright
government gives certain
grants rather than as payments for goods or services rendered.
individuals as outright grants
By subtracting taxes from gross domestic product (GDP) and adding transfer pay-
rather than as payments for
ments, we obtain disposable income:5
services rendered to employ-
ers. Some common exam-
DI 5 GDP 2 Taxes 1 Transfer payments
ples are Social Security and
5 GDP 2 (Taxes 2 Transfers)
unemployment benefits.
5Y2T

<<

. 46
( 126 .)



>>