The Circular Flow of

Economic Activity
 Assumption: economy is consist of two sectors

FIRMS (basic producing unit)

suppliers of goods and services,
hire factors of production to
produce goods & services

HOUSEHOLDS (basic consuming unit)

consume goods and services,
suppliers of factor services
own inputs of production (land,
labor, capital, entrepreneurship)
 Circular Flow of
Macroeconomic Activity
Assumption: economy is consist of two sectors

FIRMS (basic producing unit)

suppliers of goods and services,
hire factors of production to
produce goods & services

HOUSEHOLDS (basic consuming unit)

consume goods and services,
suppliers of factor services
own inputs of production (land,
labor, capital, entrepreneurship)
 Revenue Spending
MARKETS FOR
GOODS AND
SERVICES
Good and Good and
services services
sold bought

FIRMS HOUSEHOLDS

Inputs for Land, labor

Production and capital
MARKETS FOR
FACTORS OF
PRODUCTION
Wages, rent, Income
interest and profit
Flow of goods & services
Flow of money: pesos

THE CIRCULAR FLOW DIAGRAM in a simple economy

IN THE UPPER LOOP:

o the arrow emanating from firms to

households represents the sale by
firms of goods and services to
households.

o the arrow from households to

firms represents the payments.
IN THE LOWER LOOP:
o the arrow originating from the
households to the firms shows that
firms hire labor and capital from
households in order to produce
goods and services.
o the arrow emanating from the firms
indicates their payments for the use
of the factors of production.
 Circular Flow Diagram
In the upper loop:
purchasers buy final goods and
services

the total $ flow of their spending

each year is one measure of Gross
Domestic Product
 Circular Flow Diagram
Lower loop:
measures the annual flow of costs
of output:

the earnings that businesses

pay out in wages, rent, interest,
dividends, and profits
The Circular flow of final goods and
services model illustrates how the transfer of
goods and services is facilitated trough the
linkages with the different sectors comprising
the economy.

Resource Market is the exchange of resources

between the households and business firms. In
this market, the households are the sellers of
the factor inputs/resources and the firms are the
buyers.
Product Market is the exchange of the
final goods produced by the business
firms. Here the sellers are the business
firms while households act as buyers.

Clock-wise flow of the arrows presents

the flow of resources; counter-
clockwise flow illustrates the movement
of money or income flow.
Savings result when households and
business firms intend to keep a portion of
income earned from the sale of resources
and produced goods.

Savings reduces the money income to be

used as payment for resources and
consumption expenditure.

It is treated as a leakage in the circular

flow, creating distortions to the cycle.
The economy will be at equilibrium
when financial institutions make savings
available to the households and the
business firms in the form of investment.

Investment is the process of increasing

the current capital to produce more goods
and services.

Thus it is an inflow to the circular flow.

The two-sector model equilibrium
point that savings (leakage) is equal
to investment (inflow).

The manipulations involved in

controlling the behavior of saving and
investment are defined under
Monetary Policy of the country.
The three-sector model examines the
equilibrium condition of the economy
with the presence of the government.

Here savings and taxes (leakages) must

equal the investments and government
expenditures (injections) to sustain the
equilibrium conditions.
Taxes are generally all forms of contributions
collected by government from households and
business firms upon the consumption and use of
resources.

Taxes curtail the money income of households and

business firms and reduce their capacity to buy
and produce.
Government in return must use and spend
money collected for public/general
consumption.

Fiscal Policy maintains the balance between

taxes and public expenditures.
In an open economy, the fourth sector is
described as the rest of the world
(connotes the presence of other countries
engage in trading of goods and services).

The circular flow will be at its equilibrium

by balancing the imports (leakage) with
the exports (injections).
The payments for the goods purchased outside
the economy are money outflows.

The imbalance produced by importation of the

goods from other countries can be corrected
through exports.

Exports are injections from the sale of goods to

the external sector. It increases the money
income in the circular flow.

Trade Policy upholds the balance of imports

and exports.
 Total Leakage = Total Injection

Saving Investment
Taxes Government Expenditure
Imports Exports

Leakages are outflows from the circular flow of goods

and services.

Injections are inflows to the circular flow of goods and

services.